The huge inflows seen into gold ETCs in recent months combined with rising demand for inflation-linked ETFs suggests investors are concerned about a dramatic return in inflation.
While the economic picture is far from clear, the combination of government spending and central bank quantitative easing has analysts wondering whether a return of inflation is finally due after a decade-long slump.
As MJ Lytle, CEO of Tabula Investment Management, highlighted: “The economic consequences of COVID-19 have led simultaneously to forecasts that we are heading into a period of deflation, but also to forecasts that over the medium term we could see inflation or stagflation with rates of 10% or higher.”
Since the Global Financial Crisis, central banks across developed markets have had no success in bringing economies out of low inflationary levels.
“There are only two effective ways out of the combined government debt pile and central bank overdraft,” Mark Northway, investment manager at Sparrows Capital, added. “Inflation or default.”
In such periods of opacity over the direction of travel, the case for hedging your bets against a potential rise in inflation is, therefore, something investors should be considering, at the very least.
Keeping an allocation for the purposes of inflation protection, Jose Garcia-Zarate, associate director, passive strategies, Europe, at Morningstar, said is akin to an insurance policy.”
“One may grumble at having to pay an insurance premium when you do not make use of the policy, but one will really regret not having the policy in place if an accident happens.”
Although the likelihood is not for inflation to roar ahead, he added the case for topping up on inflation protection is “growing.”
“In fact, it makes total sense to target (or wish for) higher inflation levels in the future now that governments are loading up on public debt,” Garcia-Zarate continued. “So, this feels the right time to allocate to instruments that provide inflation protection if investors have not done so yet, or reassess whether your current allocation is fit for purpose to account for the risks of higher inflationary pressures in the future.”
Furthermore, Raymond Backreedy, CIO at Sparrows Capital, stressed the level of equities within a portfolio also has an impact adding that portfolios with over 50% or more equity risk offers “an element of inflation buffer offered within the equity risk premium”.
But for portfolios skewed more towards fixed income, the calculation differs.
“One needs to ascertain the mix of sovereign and inflation protection that provides for both drawdown protection and capital preservation that complements the overall portfolio risk characteristics,” Backreedy said.
For anyone worried about the effect of inflation on their investments the obvious route is inflation-linked bond ETFs.
Those with a US-biased portfolio, Garcia-Zarate said TIPS-linked ETFs would do the job while for those with a European or UK bias, then ‘home-biased’ ETFs would do the job.
“There are ETFs that provide exposure to the market of UK and EUR-denominated inflation-linked bonds which would suit the needs of UK and EUR-based investors,” he continued.
“There are also ETFs that track global linker bond markets, which may be options for those seeking a global approach to inflation protection.”
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Backreedy suggested any ETFs tracking these indices:
Bloomberg Barclays Emerging Markets Inflation-Linked
Bloomberg Barclays Euro Government Inflation-Linked 1-10 Year
Bloomberg Barclays UK Government Inflation-Linked Bond
Bloomberg Barclays US Government Inflation-Linked Bond 1-10
Bloomberg Barclays Global Inflation-Linked Bonds
Some of these indices, he added, are also configured in currency-hedged format allowing an investor to mitigate the FX currency risk if using global inflation protected bonds.
“The ETFs that tracks the (Bloomberg Barclays) indices can be used as building block for inflation protection within a portfolio.”
There are a number of inflation-linked ETFs available on the European market. In the week to 26 June, European investors poured $321m into the Lyxor Core US TIPS (DR) UCITS ETF (TIPG), a sign of increasing predictions of a return to inflation.
There are also a number of other ETFs including:
SPDR Bloomberg Barclays EM Inflation Linked Local Bond UCITS ETF
iShares Global Inflation Linked Govt Bond UCITS ETF USD
Xtrackers II Global Inflation-Linked Bond UCITS ETF 3D
Lyxor Core Global Inflation-Linked 1-10Y Bond (DR) UCITS ETF
iShares £ Index-Linked Gilts UCITS ETF
One caveat investors should be aware of when investing in “linkers” is they come with long durations.
Garcia-Zarate added: “This is particularly the case in the UK where the market of linker government bonds primarily caters for the very long-term asset/liability-matching needs of institutional clients such as pension funds and insurance.”
It means higher interest rates would “disproportionally” affect the value of long-duration bonds.
Other risks are also apparent. As Lytle pointed out, if inflation falls then investors who have bought inflation protection will be worse off.
“The difference between buying products with and without inflation protection is referred to as the difference between nominal (including inflation) and real (ex-inflation) rates,” he explained.
“However, as existing inflation rates are already quite low, both on an absolute and historic basis, it is easy to argue that the risk is skewed towards rising inflation and therefore worth having some inflation protection in your portfolio.”