Investors worried about the risks of inflation to their retirement portfolios have poured money into funds that invest in inflation-protected Treasury bonds, known as TIPS, for obvious reasons. But they may be backing the wrong horse, according to new research.
Commodities such as oil, copper and soybeans rather than TIPS are the best insurance against rising inflation, according to an analysis presented yesterday by State Street Global Advisors to a webinar hosted by Pensions & Investments, the pension industry journal. Natural resource stocks—meaning stocks in the companies that produce commodities, such as miners or oil companies—as well as real-estate investment trusts and infrastructure stocks also look like better insurance against inflation than TIPS, the analysis adds. In a nutshell, these other assets are apt to rise and fall when inflation does, but in some cases are apt to do so much more dramatically than TIPS do, which means you can get a lot more insurance for your money. State Street calculates that since 1970, when interest rates have been rising stocks and bonds have both lost you money in real, inflation-adjusted terms. But commodities have earned 24% annualized and other real assets such as resource stocks, REITs and infrastructure 9%. All of this, naturally, is based on past performance and comes with the age-old warning that past performance is no guarantee of future results. There’s another issue with TIPS which Rob Guiliano, senior portfolio manager at State Street Global Advisors, didn’t mention, but which may be paramount: TIPS today are so ridiculously expensive now that they actually guarantee you will lose purchasing power over the life of the bond. TIPS, first launched in the late 1990s, are in theory almost the perfect investment for retirees and others seeking safe and dependable income. They are issued by the U.S. Treasury, and like other Treasury bonds are safe from risk of default. You’ll get your money, come hell or high water. Meanwhile, unlike other Treasury bonds, they also adjust your payments to reflect consumer price inflation. Around 20 years ago, when TIPS were new, you could buy them and be sure that you would earn a rate of interest of 2% or even 3% a year above inflation. Today, TIPS offer rates of interest that are guaranteed to be below the rate of inflation. In other words, no matter whether prices rise 2% or 5% or 10% in the years ahead, you are guaranteed to lose purchasing power. The loss may be small—between 0.4% a year and 2% a year—but it is real. The reasons for this are various, and include the reality that TIPS are still bonds, and in the era of zero percent interest rates all bond yields have collapsed. Bonds operate like seesaws: If the price rises, the “yield” or interest rate falls. It is in this environment that the latest research is so interesting. It is widely known that inflation has surged this year: The October figure hit 6.2%, the highest in decades. Debate still rages about whether this is a short-term phenomenon caused by the massive dislocations to the world economy from nearly two years of lockdowns, or a longer-term one caused by things like government spending and deficits. Most of the people commenting on the topic seem to have a vested interest in pushing one answer or another, or a political interest. As American politics have now degenerated into a version of religious sectarianism, all political pundits should be viewed like religious fanatics yelling from soap boxes, and their prognostications as a branch of theology. This includes their prognostications on economics. As a result, when it comes to money their comments should all be treated with caution. All I know is that the bond market is currently expecting inflation averaging 2.73% over the next 10 years. That is the highest prediction made by the market this millennium, and a big jump from January, when the forecast was just 2%. On the other hand it is still a long way from the 1970s, let alone Weimar Germany. If you’re worried about inflation, State Street suggests a multistrategy approach. Giuliano says investors may want to allocate 5% or 10% of their portfolio to inflation-protected assets, though he adds some may want to go as high as 15% “or even 20%.” Whatever the number, their analysis suggests splitting the allocation across five assets: Commodities themselves, natural resource stocks, infrastructure stocks, U.S. real-estate investment trusts or REITs, as well as TIPS. (If you are allocating, say, $10,000 to inflation hedges, State Street’s multi strategy would involve $2,500 in commodities, $2,500 in natural resource stocks, $2,000 in infrastructure, $2,000 in TIPS and $1,000 in REITs.) These are all easily investible by ordinary investors: For example through the low (ish) cost ETFs of iShares Bloomberg Roll Select Commodity Strategy
SPDR S&P Global Natural Resources
iShares Global Infrastructure
Vanguard Real Estate Index Fund
and iShares TIPS Bond
(I own GNR in my own retirement portfolio). Naturally if inflation fears plunge again you may suffer losses on these. Commodities are incredibly volatile, and as they generate no income—it actually costs money to own the futures—they are a painful investment when they go against you. The latest Bank of America survey of big institutional investors also shows that commodity futures, having risen 30% so far this year already, are now especially popular with the big money crowd. If history is any guide that’s a reason to be cautious.