The rise of inflation to the current 5.3% has lots of investors thinking long and hard about how to protect their portfolios from the risk of erosion. Flashbacks to the last protracted inflationary period, which lasted across the decade of the 1970s, can raise a host of anxieties in those who lived through it.

But there are huge differences between what was going on then and what is going on now, agreed a panel of professional inflation-hedgers at the Morningstar Investment Conference in Chicago today.

“It was a unique period, with a lot of unique things happening. It’s one period, one example,” said Catherine LeGraw, an asset allocation specialist at GMO. “If we look more broadly for inflationary environments, we don’t find that many. In environments where inflation was greater than 5%, we find eight, and each one’s a little bit unique. So you can’t anchor too much to any one thing.”

The most important thing to look at is the fundamental linkage to inflation underlying an investment, she said. “You might have to see through some volatility, but at least you’ve made a good decision for the long term.”

Of course, inflation should always be considered when evaluating asset classes and allocating a portfolio, as inflation is one of the core risks that could cause a permanent reduction in the value of an asset. “There are two primary risks that can cause that permanent impairment. One would be depression risk, the risk of a huge economic growth shock, and the other would be inflation risk. Both core fundamental risks can completely ruin your portfolio’s value.”

LeGraw was joined at the Morningstar event by Evan Rudy, portfolio manager at DWS, who looks to natural resource equities, real estate, infrastructure and commodities to tamp down on loss in an inflationary period, and by Nic Johnson, managing director at Pimco, who looks to commodities.

Treasurys Absent
Noticeably absent from the discussion was the traditional go-to for protecting against inflation risk: Treasurys. Interest rates are so low that Treasurys are a non-starter these days, LeGraw said. Instead, GMO’s strategy uses natural resource equities.

“The beautiful thing about equities is they are a real asset, so equities do retain their value through time,” LeGraw said. “The problem with equities in an inflationary environment is oftentimes you see a re-rating, so essentially you’ll see some multiple compression with your equities. And that can be acutely painful in the short term.”

Part of the solution to managing inflation risk within equities is to buy the cheaper stocks, as they’re less vulnerable to this re-rating, and natural resources equities are an exceptional asset within equities at this time, she said. “They’ve got this strong fundamental link to inflation. Today they’re wonderfully cheap, so they meet that more-protected from re-rating [criteria]. And in past inflationary environments they’ve done quite well. We looked at those eight environments where inflation was greater than 5% and found in six out of the eight, [natural resource equities] did better than inflation, and in eight out of eight better than the S&P 500.”

Rudy agreed on the natural resources front, but said he adds real estate, infrastructure and commodities to stem losses in an inflationary period. “These all have very different reaction functions to inflation, both expectations and actual inflation,” he said. “Commodities and natural resources respond immediately [to], if not drive, that rise in inflation. Whereas [with] real estate and infrastructure, a lot of their top-line revenues can be bumped up by inflation. They have explicit measures within those contracts to pass through that inflation. So they can all be different inflation hedges in different ways depending on the acceleration and/or deceleration of inflation.”

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