With inflation expectations on the rise, the inflation discussion has taken center stage among listeners and market participants alike. But what should investors be considering when it comes to positioning their portfolios for the possibility of rising inflation?
On a recent episode of our Funds in Focus podcast, we spoke with Investment Strategists Mark Carlson and Ellen Chenoweth about what’s driving inflation expectations—and got their perspectives on tools for hedging inflation in portfolios. We came away from this discussion with three key takeaways:
In this episode, you'll learn
- The key drivers when evaluating for potential inflation to portfolios
- Why investors often turn to “tips” as a first line of defense against rising inflation
- How every portfolio could benefit from a strategic allocation to natural resources
#1: THE INFLATION DEBATE IS INTENSIFYING
inflation has been a hot topic over the last several months, where it's now nearly impossible to open a newspaper without seeing a headline about the inflation debate. The debate is heating up with good reason, as several key factors have been driving inflation expectations:
- Fiscal stimulus: The US government has passed unprecedented stimulus packages in response to the pandemic—which many expect will trigger an inflation surge.
- Economic recovery: With promising trends in COVID-19 cases and widespread vaccinations underway, many market participants are expecting the economy will soon reopen—spurring robust demand at a time when global supply chains are still facing shortages.
- Monetary policy: The federal reserve has continued to maintain its stance to keep interest rates low—and easy money supply has generally been associated with increasing inflation.
Each of these factors has the potential to push inflation higher—and the combination of them has intensified the debate as to whether rising inflation could be on the near-term horizon.
#2: TIPS CAN BE A LINE OF DEFENSE—BUT BEWARE DURATION DRIFT
The factors behind increased inflation expectations have the potential to drive inflationary pressures in both the short- and long-term. As such, at FlexShares we believe investors should review their portfolios for potential risks from inflation in the near-term, while maintaining an eye towards the future inflation outlook.
As high yield bonds have become more widely adopted in balanced portfolios, we’ve seen overall credit quality increase and income generation decrease. This has ultimately led to deteriorating credit premiums and a reduction in the risk and return tradeoff typically observed in the high yield market.
Treasury inflation-protected securities—commonly known as TIPS—are often what comes to mind as the first line of defense for investors expecting rising inflation. These fixed income securities have earned their reputation as effective short-term inflation hedging tools, as their principal is adjusted to reflect movements in realized inflation—giving investors a direct link to inflation.
However, investors should be aware that TIPS are often subject to duration drift, where TIPS index durations can vary drastically with changes in issuance patterns, inflation expectations, or real interest rates. For example, rising real interest rates have led to higher duration in the Bloomberg Barclays TIPS Index, exposing investors in vehicles tracking this index to unnecessary interest rate risk.
To further complicate matters, this added risk has implications for correlations as well as total returns. Over longer periods of time, those real returns and interest rates can overwhelm the inflation-linked component of TIPS. This is why we believe it’s important for investors considering TIPS to seek out strategies that are designed to address these concerns and potentially allow for better risk budgeting.
#3: NATURAL RESOURCE EQUITIES CAN BE AN EFFECTIVE INFLATION HEDGE
While TIPS can be an effective inflation hedge for the short-term, we believe a strategic allocation to natural resource equities has the potential to help address longer term inflation concerns. As we explained in a previous episode, natural resource equities can have numerous advantages over commodity futures investing—and are similarly correlated with inflation.
At FlexShares, we’ve studied natural resource equities and found the favorable characteristics can be enhanced even further by focusing on companies operating in the upstream portion of the supply chain—companies that actually own assets on the ground. This may help increase an investor’s exposure to the positive impact of rising prices, potentially boosting the allocation’s efficacy as an inflation hedge.
Please see our FlexShares Morningstar® Global Upstream Natural Resources Index Fund (GUNR) for more information on our natural resources ETF that focuses on upstream companies. Please see our FlexShares iBoxx® 3-Year Target Duration TIPS Index Fund (TDTT) and our FlexShares iBoxx® 5-Year Target Duration TIPS Index Fund (TDTF) for more information on our TIPS ETFs with targeted duration exposure.
Before investing, carefully consider the FlexShares investment objectives, risks, charges and expenses. This and other information is in the prospectus and a summary prospectus, copies of which may be obtained by visiting www.flexshares.com. Read the prospectus carefully before you invest.
Foreside Fund Services, LLC, distributor.
An investment in FlexShares is subject to numerous risks, including possible loss of principal. Fund returns may not match the return of the respective indexes. A full description of risks is in the prospectus.
FlexShares Morningstar® Global Upstream Natural Resources Index Fund (GUNR) is passively managed and uses a representative sampling strategy to track its underlying index. Use of a representative sampling strategy creates tracking risk where the Fund’s performance could vary substantially from the performance of the underlying index along with the risk of high portfolio turnover. It is subject to the global natural resource industry. As the demand for or prices of natural resources increase, the Fund's equity investment generally would be expected to also increase. Conversely, declines in demand for or prices of natural resources generally would be expected to cause declines in value of such equity securities. Such declines may occur quickly and without warning and may negatively impact your investment in the Fund. Investments in foreign market securities involve certain risks such as currency volatility, political and social instability and reduced market liquidity. To the extent that the Fund invests in Emerging markets, those investments may be subject to increased price volatility and may be more susceptible to adverse economic, market, political or regulatory occurrences affecting that country, market, industry, sector or asset class.
The Morningstar® Global Upstream Natural Resources Index is the intellectual property (including registered trademarks) of Morningstar® and/or its licensors ("Licensors"), which is used under license. The securities based on the Index are in no way sponsored, endorsed, sold or promoted by Morningstar® and its Licensors and neither of the Licensors shall have any liability with respect thereto.
FlexShares iBoxx® 3-Year Target Duration TIPS Fund (TDTT) and the FlexShares iBoxx® 5-Year Target Duration TIPS Index Fund (TDTF) are passively managed and primarily use a replication strategy to track their underlying index. Use of a replication strategy creates tracking risk where the Fund’s performance could vary substantially from the performance of the underlying index along with the risk of high portfolio turnover. They may invest in derivative instruments. Changes in the value of the derivative may not correlate with the underlying asset, rate or index and the Funds could lose more than the principal amount invested. The Funds are subject to fluctuation of yield risk, income risk, inflation protected security risk and interest rate/maturity risk. The Funds are non-diversified meaning the Funds’ performance may depend on the performance of a small number of issuers because the Funds may invest a large percentage of its assets in securities issued by or representing a small number of issuers.
The iBoxx® 3-Year Target Duration TIPS Index and iBoxx® 5-Year Target Duration TIPS Index are the intellectual property (including registered trademarks) of Markit iBoxx® and/or its licensors ("Licensors"), which is used under license. The securities based on the Index are in no way sponsored, endorsed, sold or promoted by Markit iBoxx® and its Licensors and neither of the Licensors shall have any liability with respect thereto.