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Categorized | Equities

Investors keep trimming inflation hedges

Posted on November 20, 2014


Inflation has become the dog with no bite during the era of aggressive central bank policies, casting uncertainty over portfolios meant to safeguard against climbing prices.

For years, conventional wisdom on Wall Street dictated that slumbering interest rates and the massive expansion of balance sheets by the likes of the US Federal Reserve would ignite inflationary pressure. Instead, inflation is running below target in most of the largest economies including the US, which Thursday reported no change in consumer prices between September and October. In Japan and the eurozone, signs of disinflation are mounting.

    These facts challenge a trend sparked by quantitative easing. Alarmed by central banks’ experiments in monetary policy, investors sought inflation protection via commodities and inflation-linked bonds and derivatives.

    Commodities are headed for their fourth consecutive year of losses, with the Bloomberg Commodity Index down 7 per cent so far in 2014. Gold – a classic haven from inflation – sits well below its peak at $1,180 per ounce. Inflation-linked bonds in the US, UK and eurozone signal no significant risk of sharply rising consumer prices.

    “We are in a secular moment of low inflation due to technology and energy innovation, and that could last for three to five years,” says Rick Rieder, chief investment officer of fixed income at BlackRock.

    He believes US inflation will remain low and below historical norms, but worries that a lack of aggregate demand in Europe and Japan could well result in disinflation affecting their economies.

    So far this year investors have pulled $17bn from commodity index products tracking baskets of futures from oil to cotton, more than double the outflows in all of 2013, according to Barclays estimates. Exchange traded funds backed by gold have dumped 4m troy ounces of bullion as prices gave up gains for the year, Bloomberg data show.

    James Steel, a precious metals analyst at HSBC, says: “We had a lot of buying between 2008 and 2012 in the gold market based on the likelihood that quantitative easing . . . would eventually trigger inflation. As that is patently not the case, this inflation hedge money has come out of the market.”

    A broad index of US Treasury inflation protected securities (Tips) has generated a total return of nearly 5 per cent this year, while long dated holdings are up some 15 per cent according to Barclays Indices. Nevertheless, the iShares Tips bond exchange-traded fund has seen $466m of outflows this year, according to

    The asset management group Pimco has tens of billions of dollars invested in both commodities and inflation-linked bonds. Nic Johnson, a Pimco portfolio manager, thinks “now is a pretty attractive time” to add inflation protection.

    Mr Johnson is of two minds about the two asset classes, however. “We don’t expect a meaningful bounceback in commodities,” he says, citing factors such as the slowdown in oil demand growth.

    He calls Tips “cheap”, saying the market is mistakenly assuming the Fed will fail to meet its inflation objectives. “We expect incrementally higher inflation as you move further in the economic cycle,” he says.

    Since the end of October, $146m of money has flowed back into the iShares Tips ETF, suggesting some believe a buying opportunity exists. The market has rebounded sharply from 2013’s year of negative returns that sparked a $7.9bn outflow from the sector.

    The risk, however, may be a market that remains cheap for much longer than investors think.

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    Richard Gilhooly, a strategist at TD Securities, says the US inflation market is experiencing a further washout after 2013 was a negative year of performance for an asset class established in the late 1990s.

    “Investors can look at the long term, but one issue with Tips is that they haven’t been around that long and have suffered from a lack of liquidity and manipulation due to the Fed’s QE policy,” he says.

    Tips at least pay a yield to investors. Commodities do not, and in fact holding futures can eat into returns when prices of futures markets slope upwards – as they currently do in oil, gold, corn and cotton.

    “We’re generally looking for strategies where we’re not just sitting around waiting for inflation to materialise to get returns,” says Christian Busken, director of real assets at Fund Evaluation Group, an investment consultant to endowments and foundations. “That’s kind of the case with commodity futures – it’s sort of this insurance policy against inflation spikes.”

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