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As we baby-step our way into 2017, two events are a presumed given: interest rates will rise, and volatility will be a fact of life. And while it may be easy to jump to the conclusion that inflation is also heading our way, it is definitely not a given. So what’s an advisor to do? How can you plan for what’s coming down the track when you (like everyone else) have blinders on? The trick is to reframe how you think about hedging the risk of inflation. Here are three steps that may help:
Step 1: Reconsider your use of TIPS.
Treasury Inflated Protected Securities (TIPS) are often a go-to strategy in the face of inflation. But what if inflation simply doesn’t happen? You don’t have to look too far back into history to remember the market’s Taper Tantrum in 2013. The Fed announced it was going to cut back the bonds and mortgage-backed securities program, and suddenly fixed income risk assets were the very last thing anyone wanted in their portfolios. The same thing happened immediately following the recent presidential election. Trump’s policies created huge expectations of inflation, but while we’re still in the early days, so far nothing has happened . In both of these cases, TIPS simply did not work as a hedge.
The truth is, no one can predict how the economy will react in the future. And if inflation doesn’t materialize in a rising-interest-rate environment, the impact on your portfolio can be devastating. If you do choose to use TIPS, at the very least recognize this potential disconnect between interest rates and inflation—and that a TIPS strategy may be a whole lot riskier than you may have thought in the past.
Step 2: Include short-term bonds in your core satellite.
Because bond prices and yields have an inverse relationship, rising interest rates inevitably cause bond prices to take a hit. This means that inflation exposure is embedded into short-term instruments and baked into returns over the long term. During the recent period of historically low interest rates, longer-duration bonds made sense. But knowing that the Fed has indicated a slow-and-steady approach to raising interest rates, shortening duration is probably a very wise move.
Whether you buy short-term bonds directly from the Treasury or through an ETF, gaining exposure to shorter-term bonds with lower duration can help pick up increasing coupons. (This is the very reason IndexIQ uses this strategy in our own ETF products.) Using short-term bonds as a core-satellite can help reduce your overall risk.
Step 3: Add niche satellites to gain inflation exposure in unexpected areas.
Regardless of whether or not inflation is realized in the broader market, it is likely to be found in certain niches, which can make including a few carefully selected vehicles as a satellite can help support hedging. For instance, while some investors may be busy pulling real estate investment trusts (REITs) from their portfolios with the assumption that REITs won’t do well in the face of rising interest rates, that’s not necessarily the case. Consider that we seem to be poised for a period of healthy inflation; interest rates are rising in part due to higher wages and increasing consumer confidence, which can lead to higher property values and occupancy rates. In such an environment, REITs may actually make a whole lot of sense as part of a core-satellite. The same is true for commodities, oil, and gold (if you’re willing to stomach the volatility). They’re less perfect, but that’s precisely what can make them smart tools when used as small, niche investments.
Currency is another interesting candidate for niche satellite exposure. Because inflation affects the value of a given currency relative to other global currencies, when used carefully, this too can be a strong option for hedging inflation. Mexican investors knew this well when they moved money into U.S. banks as the peso plummeted in value in the 1990s. More recently, investors who foresaw the Brexit vote (there weren’t many!) were able to take advantage of the drop in the value of the pound compared to the US dollar. If there’s a currency opportunity to be had, it’s an option to consider when building your satellite positions moving forward.
No matter what strategy you use, remember that just as all assets in the market aren’t correlated, neither are all market indicators. Rising interest rates can indicate inflation—but not always. The Fed may increase interest rates at the Federal level, but participants in the market don’t always follow suit. Inflation may negatively impact purchasing power, but actually lead to an increase in corporate earnings and, in turn, equity prices. As you create your strategy for 2017, remember that the goal (always!) is to protect your portfolio from inflation without overexposing it to volatility. A careful, strategic approach to hedging may feel as boring as watching paint dry, but in times like these, taking the excitement out of investing may be exactly what you—and your clients—need most.
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IndexIQ®is the indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.