The investment experts at Franklin Templeton spend a lot of time speaking to chief investment officers about “What if . . .” That is, the most beneficial discussions come from exploring the implications of what might happen—not guessing the future—and being prepared for those risks.
In the following conversation, two key players at Franklin Templeton Multi-Asset Solutions—Wylie Tollette, Head of Client Investment Solutions, and Gene Podkaminer, Head of Multi-Asset Research Strategies—consider the “what if” of inflation, including why it’s like a ninja (and a bit like cholesterol)
Wylie Tollette: Inflation is one of the more underappreciated risks out there. We’ve seen some recent CPI data for developed markets that have popped a little bit above expectation, raising a flag somewhere between green and yellow—to the point where we would recommend an in-depth understanding of how inflation risk translates across both assets and liabilities within the portfolio. Many liabilities—pensions, insurance, salaries, etc.—are tied to CPI.
Gene Podkaminer: This lime-colored flag we’re waving, it’s part of the portfolio and yet, oftentimes, it’s hidden. You’ll see exposure to inflation, in real estate certainly, in commodities absolutely, and in TIPS and linkers. You can quibble with the supply and demand issues of TIPS pricing, or if CPI is a great inflation measure, or whether it should be the GDP deflator or something else. But within TIPS, you do have actual exposure to inflation. Arguably, over longer periods of time, you will feel it in the equity markets also. To me, what’s interesting about inflation is that global growth is a well-known factor. Interest rates are well-known, well-appreciated. But inflation hasn’t gotten a lot of air time.
Tollette: A high inflation environment is unfamiliar to most people in developed countries. We haven’t seen high inflation in the US or most developed markets since the 1970s. Many portfolios have drifted away from explicit inflation hedging, which tends to be costly. People can tolerate the price, stand the opportunity cost for a few years, but then they get tired of paying to own commodities or specific inflation hedges or swaps, so they give up on that. That may be a rational choice, actually—to look for intrinsic inflation hedges that are built into other asset classes, such as in rental real estate, that don’t have the same opportunity costs.
Every investor has to think very carefully about their time horizon in relation to what risks they want exposure to—what’s their genuine time horizon, because when you’re in the thick of a difficult financial market fire, it can be very difficult to stay focused on the elusive longer term. You have to set yourself up ahead of time to do that. That’s very true for inflation in particular, which is an area where developed market CIOs could maybe take a few lessons and cues from some emerging market CIOs. If you look at a pension plan in Brazil, for example, which has seen consistent double-digit inflation for many years, there are tools built into their asset allocations to help address inflation risk in a way that we haven’t necessarily had to in some areas of Europe or in the US for quite some time.
Podkaminer: What we’re seeing now is more of a reflationary environment. When I’m thinking about inflation, it’s kind of like cholesterol: there’s good inflation and there’s bad inflation. I want to see good inflation that’s caused by productivity increasing in economies, by things overheating because we have healthy consumption. That, to me, is relatively good inflation. We understand how that cycle works and how to deal with it. Bad inflation is what you see happening in a lot of emerging markets where you’ve got very little control over monetary policy. As you relinquish that control, you start to see interesting things happening to your home inflation rate and also to your currency. That’s the bad cholesterol.
The inflation sensitivity in portfolios that are housed in developed market currencies are still important thing to consider. When we speak with CIOs in the US, we hear a lot about inflation, but I’m not necessarily seeing it flow through into their investments. I believe that it’s important to stop and take a look, and understand what changes in inflation could mean to the assets in portfolios, and come up with a game plan to address those changes. If inflation does spike in the developed markets, that could have a huge impact on what the portfolios look like, and not just how it relates to liabilities. Inflation could cause tremendous dislocation.
Tollette: Inflation is perhaps the factor most explicitly tied into many liability structures. If you’re a university endowment, salaries, expenses, and tuition have dramatically outpaced core inflation. If your endowment portfolio was tied to CPI, you probably undershot the mark in terms of how your liabilities around that have expanded. It’s important to understand what currency those obligations are denominated in, because even if the underlying cost driver isn’t changing that much, that currency may have an inflation component. This is important to think about as you’re structuring your portfolio to make sure your cash flows that come in are structured in the currency the payments need to go out in.
Podkaminer: Inflation is a ninja—you heard it here first. A shock to global growth will flatten you, but you’ll see it coming. Interest rates maybe are a little bit subtler; but again, you can see that coming. Inflation will kill you in stealth.
Tollette: It can creep up on you year after year. If you’ve counted on 3% inflation on your asset side and that’s what you targeted to achieve, but your obligations are increasing by 4%, that might not look like a lot in any given year. Over 10 years, however, that will create a real funding problem.
Podkaminer: We see intelligent investors couching their return expectations or their return objectives in real terms, which makes a lot of sense. Say you want to achieve 3.5% real. If inflation happens to be 4%, that’s okay. And if it’s at 2%, even better—at least the focus is on what you can control, which is the real portion of returns, and not being surprised when inflation isn’t what you expected.Tollette: It always goes back to what’s the money for, and how that should influence your asset allocation and your benchmarking policy, and how you think about success and whether you’re increasing the probability of achieving your goals and your aims.
Wylie and Gene are happy to speak to you about your “what if” scenarios. Feel free to contact them at firstname.lastname@example.org:
Wylie Tollette, CFA, CPA
Head of Client Investment Solutions
Franklin Templeton Multi-Asset Solutions
Gene Podkaminer, CFA
Head of Multi-Asset Research Strategies
Franklin Templeton Multi-Asset Solutions
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