As coronavirus fears wane and global economies start to recover on the shoulders of stimulus, there has never been a more important time for investors to think about inflation and what it means for their portfolios. For the past 30 years, investors have experienced only relatively low levels of inflation and balanced portfolios made up of stocks and bonds have done a reasonable job of delivering returns above inflation. But what if the inflation we have started to see continues?
The simple answer is that the traditional 60/40 portfolio of stocks and bonds won’t cut it. Instead, investors will need to augment their portfolios with asset classes that are directly or indirectly linked to physical assets that are positively correlated to inflation and are expected to maintain their real value over time. Purpose Diversified Real Asset Fund (“PRA”) combines exposure to commodities, related equities, and real estate to capitalize on the inflation theme set to play out over the medium term.
The current policy environment
Driven by widespread vaccine rollouts and re-accelerating economic growth, investors are seeing inflation creep up as an explicit objective of post-pandemic monetary policy.
- Central banks have communicated a willingness to allow inflation to run temporarily above target ranges to restore the pre-pandemic growth trajectory. For example, due to the average inflation policy, the Fed allowed prices to rise 4% over the last 12 months – well above its 2% target.
- The economy, while showing signs of recovery, may be too fragile to withstand interest rate hikes, stalling Fed intervention. As such, the Fed has kept rates at the 0-25 bps range and communicated that the rate hike isn’t expected to occur until late 2022 or early 2023. The Fed has decided to take a wait-and-see approach before committing to making any moves.
- As a result of new variants and sporadic re-openings, the Fed continues its “be patient” mantra and plans to maintain its super-easy monetary policy that was executed at the start of the pandemic. This policy entails adding treasuries and mortgage-backed securities to the balance sheet at a pace of $120 billion a month. However, as the economy rebounded in mid-2021 and the balance sheet is now more than double pre-pandemic levels, Fed officials began talking of a “tapering” – though it is still unclear when tapering will start and to what magnitude.
- Globally, record stimulus is driving continued strong growth recovery from the pandemic-related disruption. The extra cash for households, businesses, and others will largely flow straight through to demand, placing upward pressure on prices.
The relationship between inflation and real assets and commodity-linked equities
- Unlike traditional stocks and bonds, which are negatively correlated to inflation rates, real assets including precious metals, commodities, real estate, land, equipment, and natural resources are positively correlated with inflation.
- Because of this positive correlation, real assets can act as a portfolio hedge against inflation and its negative consequences on bonds and equities more broadly.
- Dollar-denominated real asset prices can also be impacted by the declining value of the US dollar (which stems from monetary-led inflation), as it reduces the cost for foreign buyers who then increase their demand for commodities.
PRA’s strategy and advantage over traditional commodities indices
A common way to gain exposure to inflation-sensitive assets is through a commodity basket whose performance can be broadly measured by indices such as the Bloomberg Commodity Index (BCOM) or the S&P GSCI (GSCI). Because of their direct exposure to commodities, these indices are great at providing downside protection, however, they only keep pace with broader equities in the highest inflation regimes and can otherwise result in return drag. PRA addresses this disadvantage by holding both direct commodity exposure in metals, grains, and energy, and exposure to cyclical commodity-linked equities that benefit even from low to moderate inflation. PRA follows a risk-parity-based asset-allocation strategy designed to weigh each asset based on an equal volatility contribution to the overall portfolio. As of September 30, 2021, equity exposure constitutes 2/3 of the Fund’s risk, with direct commodity exposure making up the remaining 1/3. The top five commodities from the energy, agriculture, base metals, and precious metals universe are selected based on the attractiveness of their forward price curves and positive price momentum.
A comparison of PRA’s performance versus these commonly used commodity indices showcases why a more robust portfolio construction methodology using multiple real assets is more pragmatic over a longer lookback:
PRA has delivered considerably better-annualized performance versus both the GSCI and BCOM across various time frames and has done so at a reasonable volatility level. Clearly, the life of the Fund has coincided with a period of low inflation, but now is the time that strategy and catalyst are coming together to create an attractive investment opportunity.
In general, PRA attempts to provide investors with a smoother ride within the realm of real assets using diversification. With the resurgence of inflation we expect to see for the remainder of 2021 and beyond, commodities and real assets can prove to be an important performance driver and hedge within a broader portfolio. PRA is a complete risk-managed solution that can help investors fulfill this crucial role.
— Claire Vaughan is a Product Analyst at Purpose Investments
All data sourced from Bloomberg unless otherwise noted.
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