Investors Are Unprepared for a Long-Forgotten Risk
Inflation is likely coming and it requires some creative portfolio construction, according to new research from Fidelity.
With the unprecedented rise in global debt, Fidelity Investments is urging investors to rethink many of the long-held assumptions underpinning how they allocate money to different investments.
“The inexorable trend of rising debt/GDP ratios is becoming the single biggest risk factor in investment portfolios,” according to new research to be published later this week by Fidelity Investments. “This has important implications for plan governance and strategic asset allocation.”
Total global debt rose from 138 percent of GDP in 1980 to 243 percent in 2018, according to Fidelity. Sovereign debt more than doubled during the period, and the pandemic has only added to those numbers. Debt will upend strategic allocation, which drives 85 to 90 percent of an investor’s results, the firm argued.
“However, deciding what will drive your strategic allocation is extraordinarily complicated,” said Vadim Zlotnikov, president of Fidelity Institutional Asset Management, in an interview. “Because of the complexity you want to be anchored to at least some things that are fundamentally knowable, such as demographics. One of the things that is becoming knowable is global debt relative to GDP.” That metric “will have a significant impact on future return distributions of different asset classes and the correlation between asset classes,” Zlotnikov went on.
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But rising debt doesn’t always lead to inflation. The government’s debt issuance caused inflation in Japan in the 1940s, for example, but similar policies in the country led to disinflation in the last few decades.
Given that, Zlotnikov believes the most controversial aspect of the new paper will be the prediction of imminent inflation. “Inflation-sensitive assets are cheap. There is a buildup in belief that inflation will never surface again. But until now we have not seen coordination between fiscal and monetary policy,” he said.
If the coordination continues, rising inflation and inflationary expectations are likely, according to Fidelity.
Kathryn Kaminski, chief strategist at AlphaSimplex Group, agrees that global monetary policy decisions, rooted in the last global financial crisis, laid the foundation for inflation. Pro-inflation policy has “accelerated to the point that it’s a given. It’s like trust. If people think they” — central banks/federal governments — “are going to intervene, it creates a natural put option on the markets,” she said.
In 2008, people believed that expansionary policy would immediately create inflation. Not so today, Kaminski stressed. “My concern is now we are saying, ‘this won’t cause inflation.’ The first time you put your toes in the water and you don’t get bitten by a shark and you think, ‘This is great’ — and then you go swimming all the time on Cape Cod, and you might run into a shark. Quantitative easing has really accelerated that activity, this natural sense that there is going to be a natural infusion of support, which at some point has to have an impact.”
According to Fidelity’s research, Investors should shift their portfolios in a number of ways, including adding non-U.S. securities as well as adding inflation-resistant assets, many of which are trading at historic lows. Treasury Inflation Protected Securities, or TIPS, and commodities are two examples.
Although there will still a big capital preservation role for bonds, the research predicted bonds will increasingly correlate with stocks if inflation resurfaces.
Investors should think about diversifying their portfolios by what the research authors called “investment time horizon.” These assets include alternatives such as managed futures (short-term time horizon), equity long/short (medium, and distressed debt (long). The research also argued that investors should rethink economic sectors that have historically been negatively correlated to inflation, such as financials. “Be sensitive to what will benefit from inflation today, not just what benefited from inflation in the past,” Zlotnikov said.
“There is no silver bullet. But we believe that seeking alternative sources of diversification outside of the most popular trades will provide greater resilience to strategic asset allocations,” according to the report.