How have our portfolios defended against recent inflation? Is inflation or disinflation in our future?
Recent inflation headlines have been startling: “Lumber prices spike to an all-time high,” “Oil prices double over the past year,” “Copper hits a 20-year high”. These quotes have caused many to believe a new cycle of rising inflation is upon us. However, for all who quote these commodity prices, others point to the rise being transitory, morphing back into disinflation in the future. Which “flation” should we expect, and how is your Osborne Partners portfolio positioned for both scenarios?
First some background. In addition to overall commodity inflation, consumer price inflation has leapt in recent months. The headline Consumer Price Index (CPI) inflation rate touched 5.0% in May, the highest reading since 2008, with Core CPI (excluding more volatile food and energy prices) touching 3.8%. Core CPI is shown below – note the severe spike.
What caused these inflation readings to launch, and what components have the highest effect on the inflation rates? The seeds of the inflation build up were planted when the economy abruptly closed due to the pandemic. The combination of total personal income rising due to an unprecedented increase in transfer income from the pandemic-induced unemployment programs, and a reduced amount of consumer spending due to consumers being locked indoors, resulted in an upward spiral in the personal savings rate (chart below) from 7% at the start of 2020 to over 27% by mid-2020.
As the economy reopened and pent-up consumer demand was high, consumers began to spend heavily. Unfortunately, goods production that shrank in 2020 caused a disequilibrium between supply (low) and demand (high). This surge in demand caused prices to rise. Some price increases are likely shorter-term reversals from plummeting prices caused by the pandemic – like airline fares and lodging. Meanwhile other price increases were caused by both a rebound in demand and raw materials shortages – like automobiles, trucks, RVs, and boats.
By dissecting the recent Core CPI data, a case can be made that these price increases are transitory. If Core CPI is divided into two broad segments, Services and Commodities (excluding Energy), the culprit is certainly Commodities. With many Commodities already steeply off of recent highs, one can assume price increases slow in the future.
What about the Services segment? Are there components within Services that are potentially artificially high? Yes. In the table below, we further divide the Services segment by showing three of the largest components which comprise 60% of the entire Core CPI. The three: shelter, medical care, and education increased at a modest 2.1% over the past year. Tack on new cars and trucks, and in total approximately 90% of CPI rose 3.4% (versus 3.8% from the entire Core CPI). We will call this reading Core CPI excluding Transport Services (expenses like airline fares, motor vehicle insurance, taxis), Used Vehicles, and Apparel. Next, if you simply assume the Commodities component fades to an above average 4% year-over-year growth, suddenly Core CPI registers a less frightening 2.7%, but well above the long-term average.
After concluding inflation is high, with a strong probability of peaking, but potentially continuing to trend above the long-term average, how should a portfolio be positioned for this outcome? First, when inflation began to rise, many investors concluded the proper positioning was to simply buy gold – a historically good inflation hedge. Bad choice.
Gold and gold ETFs have not posted a new price high in over ten months, and are nearly unchanged over the past year (6/30/20-6/30/21). Since gold was a failure during the recent inflation hype, what has succeeded? Osborne Partners believes the proper inflation hedge is a combination of asset class exposures that provide both an inflation hedge and strong fundamentals that can equate to price appreciation in all environments. Where are these inflation hedges found in your Osborne Partners portfolio?
The Osborne Partners portfolio captures any lasting uptick in inflation within numerous asset classes. First, in Natural Resources, the entire asset class (which is the strongest performing asset class thus far in 2021) should perform well. Within Natural Resources, our overweights in assets with high sensitivity to inflation such as copper and energy have led our performance since the spring of 2020. Next, in Domestic Equities our overweighting in cyclical assets such as materials, industrials, and energy have been tailwinds. Additionally, due to superior valuations and positive reward-to-risk ratios, we are overweight emerging markets in the Foreign Equities asset class. Emerging market economies tend to have exposure to commodities – another tailwind. Finally, we dramatically increased our exposure to the Real Estate asset class in the spring of 2020 by adding residential homebuilders, commercial real estate services, and REITs. Real estate tends to experience higher than average returns when inflation is elevated. In fact, when inflation is over 3%, history points to annualized returns of over 15%.
The final question to ask is, what happens if the entire inflation fear is transitory, and inflation falls from a high level? According to a number of economic quantitative teams, areas like emerging markets and real estate continue to be leaders. A table from JP Morgan’s global team is shown below:
The recent inflation scare may continue into the future at an above trend “inflation” rate. Conversely, the entire fear may be transitory and “disinflation” is seen from here. Either way, by selecting investments in all asset classes that possess both an inflation hedge and a strong fundamental story can enable a portfolio to hedge inflation and appreciate when inflation…deflates.