In the fifth video in our asset allocation series, Kevin Barr, head of SEI’s Investment Management Unit and Jim Smigiel, SEI’s Chief Investment Officer discuss inflation protection in a diversified portfolio.  

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Transcript

Kevin Barr - Hi, I'm Kevin Barr. Head of SEI's Investment Management Unit. Welcome to the fifth video in our asset allocation series. Today we'll be talking about inflation protection in a diversified portfolio. I'm again joined by Jim Smigiel, SEI's chief investment officer. Jim, thanks for joining me today. Can you tell us a little bit about why inflation is something that you should worry about when building a portfolio? 

Jim Smigiel - Sure. At the end of the day, every portfolio's goal is to support some kind of spending objective. It might be in the near term or it might be far off into the future. But ultimately, investors are trying to preserve and grow wealth that can fund their lifestyle needs and their legacy objectives. With that said, regardless of how or when investors intend to spend their assets, it's important to help prevent the effects of inflation from eroding the value of their portfolio. That is its purchasing power over whatever timeframe. Whether the portfolio is an individual saving for retirement or an endowment created to support a university, it's important that it can sustain or ideally expand its ability to purchase goods and services over time regardless of what happens with inflation rates.

Kevin Barr - So when we think about trying to build a portfolio that can withstand the effects of inflation, what types of assets are we really talking about here?

Jim Smigiel - Good question and there are a variety of options that we may consider. The most straightforward asset would be inflation-linked bonds where the principal and interest payments are tied to an inflation measure such as the US consumer price index. For investors seeking higher returns while maintaining inflation sensitivity, we may allocate two commodities which are important components of the typical consumer basket of goods and services, meaning that their price sensitivity to inflation can be seen directly as the commodity prices rise and fall. They can also be seen indirectly through the impact of those price changes on the prices of final goods that we consume. Depending on the options available, we might consider multi-asset investments which allow for diversification as well as the ability to quickly make shorter term dynamic changes in response to changing market conditions by switching amongst a broad array of inflation sensitive assets.

Kevin Barr - Does that over-complicate things? Aren't equities a reliable inflation hedge?

Jim Smigiel - We do get that question fairly often and the answer to that is no. Even over long time horizons, equities aren't a terribly reliable hedge against inflation. We've seen several 10-year periods during the last century in which equities not only failed to keep up with inflation but actually lost over a third of their purchasing power. This means that by the end of one of those 10-year periods and all equity portfolio could have only afforded to purchase two thirds of the goods and services it could have funded at the beginning of that period.

Kevin Barr - Jim, walk us through the macro considerations here. Why should investors be thinking about in terms of the environments where equities won't necessarily protect them against inflation?

Jim Smigiel - In some cases inflation is a sign of a healthy, growing economy and it's not a problem for growth assets like equities. We would argue that our portfolios are well prepared for those types of environments since a good portion of their risk budgets are allocated to equities. The bigger question is about environments in which inflation isn't so well behaved. These might be periods of supply shocks where inflation actually starts to choke off growth or they could be settings in which the economy is overheating and central banks have to step in to cool things off potentially hurting the price of not inflation sensitive bonds and the price of stocks as well. There's a reason that essentially every central bank in the world tries to keep inflation from becoming untethered from its targeted level. Once inflation reaches the point of being harmful to the economy, it's hard for growth assets like equities to perform well. If you've seen our prior videos, you know that traditional portfolios often allocate nearly all of their risk to equities, meaning that they're only prepared for well-behaved inflation. Our portfolios aim to be prepared for inflation in any type of environment. We allocate to equities which should do well when inflation is well-behaved and we also allocate to pure inflation related assets which would fare better than equities and other growth assets during periods of unanticipated inflation. One way we like to think about this is in terms of economic regimes. With one dimension being rising or falling inflation and the other dimension being rising or falling economic growth. We ask ourselves which regime are different asset classes well-prepared for? For example, when growth is rising and inflation is falling most asset classes should perform well, particularly growth oriented ones like equities and nominal bonds. However when both growth and inflation are falling, traditional nominal bonds, which do not offer any inflation adjustment will generally perform well as central banks cut rates to stimulate economic growth. The right hand side of this exhibit is more interesting as both growth and inflation are rising, so-called scarcity assets like commodities and physical assets such as precious metals and real estate become more valuable. Particularly if the economy risks overheating. On the bottom right where inflation is rising and growth is falling, the dreaded stagflation scenario, asset classes like inflation linked bonds become crucial as traditional stocks and nominal bonds are unlikely to deliver strong returns in this particular economic regime. In building strategic portfolios, our role is to make sure that we're not creating portfolios that rely on the dominance of any one or two of these regimes to achieve our objectives. Rather, we aim to deliver reasonable results regardless of which regime emerges. This means allocating to a variety of asset types in an effort to create portfolios that are well-prepared for any kind of inflationary environment.

Kevin Barr- That's a great way to think about it and a perfect place to end our discussion. The next time we get together we'll provide our perspective on incorporating high yield and emerging market debt exposure as part of a diversified portfolio. Thanks again Jim.

Jim Smigiel - Thank you.

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Commodity investments and derivatives may be more volatile and less liquid than direct investments in the underlying commodities themselves. Commodity-related equity returns can also be affected by the issuer’s financial structure or the performance of unrelated businesses. The value of a commodity investment will rise or fall in response to changes in the underlying commodity or related benchmark or investment, changes in interest rates or factors affecting a particular industry or commodity, such as natural disasters, weather and U.S. and international economic, political and regulatory developments.

Bonds and bond funds will decrease in value as interest rates rise. High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments. TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds.

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