The inflation factor: Implications for portfolio construction

During the past 25 years,

inflation hasn’t been a major

worry, but it should still be on

investors’ radar today.

means factoring in a variety of risks, including those that currently appear benign. Like erosion in the natural world, inflation’s insidious long-term effects may be devastating, particularly for investors living on a fixed income in retirement.

What is inflation and why does it matter?

Inflation is broadly defined as a general increase in the price levels of an economy. Deflation, or negative inflation, is the opposite – a general decrease in price levels. Inflation is one component of the economic cycle and is frequently linked to the overall health of the economy. Fear of inflation also has a major influence on economic policy decisions.

Since the 1920s, U.S. inflation has ranged from a deflationary -10% to a high of +20% as measured by the Consumer Price Index, or CPI, resulting in an average annual inflation rate of about 3% (see Figure 1). The CPI is the standard measure of inflation based on the cost of goods purchased by average U.S. households. Historical data collected by the U.S. Bureau of Labor Statistics dates back to 1926.

The inflation factor:

As the chart shows, inflation has been more common than deflation, although it has been relatively tame – 6% annually or less – since 1991. The last period of significant inflation was in the early 1980s; the last significant deflationary period was more than 50 years ago.

So in some ways, we are out of practice in dealing with inflation, because it hasn’t been a meaningful factor for such a long time. Concern about inflation remains fairly constant, however, because of its potentially serious effects on the economy.

The effects of inflation

In the most basic terms, in periods of inflation, rising prices often lead to an increase in consumption. Demand for goods and services increases because consumers fear that prices will be even higher in the future. But while nominal economic activity rises, real economic activity may be stagnant or falling. Assets not tied to overall price levels may lose real value as their future cash flows are eroded. For investors, this can result in a loss of purchasing power if returns don’t grow at a rate sufficient to keep up. In rare cases, hyperinflation may occur, a situation in which prices rise very rapidly as a currency loses its value. As a rule, normal inflation is reported on an annualized basis. Hyperinflation is generally reported over shorter time frames, such as days or months, and is often associated with political or social upheaval. To put this in context, at an annual inflation rate of 3%, it would take prices 24 years to double. At a daily inflation rate of 3%, prices would double in 24 days.

What about deflation?

A deflationary environment may create the opposite scenario. Falling prices tend to slow consumption because individuals and businesses delay purchases knowing they will be cheaper in the future. Sales figures slump, and companies are not

able to grow. That is why inflation/ deflation expectations are one of the key drivers of interest rates – the short-term and long-term price of money.

Figure 1: History oF u.s. inFlation 1953–2012

-3 0 3 6 9 12 15 18 2012 2007 2003 1999 1995 1991 1987 1983 1979 1975 1971 1967 1963 1959 1955 1953

Year over year %

INFLATION: U.S. CPI

Source: Morningstar, Natixis Investment Strategies Group

Source: Bloomberg, Natixis Investment Strategies Group -3 0 3 6 9 12 15 18 2012 2007 2003 1999 1995 1991 1987 1983 1979 1975 1971 1967 1963 1959 1955 1953

Year over year %

INFLATION AND INTEREST RATES

UST – 10 Yield US Inflation (CPI YoY)

Inflation and interest rates While inflation and interest rates don’t move in lockstep, they have historically trended in the same direction. In fact, interest rates have an expected inflation rate embedded in them (see Figure 2). Today, U.S. inflation remains modest by almost any measure, continuing its downward trend of the past 20 years. Historically, inflation peaked in 1981 at about 15%, and the yield on the 10-year U.S. Treasury peaked about a year later, at 15.3%. Inflation reached a 60-year low in 2009, while 10-year Treasury yields were at 50-year lows. With inflation and interest rates at historical low points, deflation is also a very real concern, because unlike interest rates, inflation can be negative.

Inflation, interest rates and traditional assets

The low interest rate/low inflation scenario presents a challenge for investors. While today’s ultralow interest rates can only stay the same or go up, deflation could bring the inflation rate into negative territory, and most risk assets perform poorly in a deflationary environment.

Figure 3 shows the long-term returns for common asset classes since 1926, relative to inflation. Historically stocks, especially stocks of smaller companies, have provided the best real returns, but inflation affects each asset class in different ways, particularly over shorter time periods.

Stocks overrated as an inflation hedge

While history shows that stocks have outpaced inflation, that doesn’t mean

they are necessarily an effective hedge against it. Broad stock indexes have outrun inflation over long time frames in large part because inflation helps them increase their share prices over time. This is one reason investors should maintain exposure to stocks for long-term returns. But stocks offer little protection against shorter-term inflation spikes, because equity returns are driven more by corporate and economic fundamentals. Furthermore, inflation doesn’t necessarily affect all stocks in the same way, so averages may be misleading. Some companies have a greater ability than others to pass price increases through to consumers, based on different cost structures and distribution mechanisms. In periods of prolonged deflation, however, financial assets tied to businesses, such as stocks, have historically performed very poorly. Slower sales cycles and the need to keep

prices low tend to limit the growth that contributes to higher share prices.

Bond returns vary by security type Bonds have a more predictable relationship with inflation, but that relationship varies by the type of bond (see Figure 4). Generally speaking, bonds are issued at an interest rate that reflects the current inflationary environment. Corporate bonds may be less likely to suffer when inflation is high, because their returns are less tied to interest rates. Conversely, long-term Treasuries, municipal bonds and agency bonds may be more affected by higher interest rates caused by inflation.

In a deflationary environment, safer assets tend to perform well initially, as the contraction of economic activity results in lower interest rates. However, if the deflationary period is prolonged, interest rates eventually bottom out,

0% 2% 4% 6% 8% 10% 12% 14% 16% U.S. Inflation (CPI) 30-Day U.S. T-bills U.S. LT Gov't Bonds U.S. LT Gov't Bonds U.S. LT Corp. Bonds U.S. Small-Cap Stocks S&P 500 Returns percentage 2.98% 2.98% 2.98% 2.98% 2.98% 2.98% 2.98% Inflation “Real” Returns 9.84% 11.95% 5.36% 6.11% 5.69% 3.54%

Figure 3: net average annual perFormance oF popular asset classes aFter inFlation 1926–2012

Source: Morningstar, Ibbotson Associates. Past performance is no guarantee of future results. The rate of inflation has averaged 2.98% from 1926 to 2012 as reflected in the chart.

leaving bond investors with no capital appreciation potential and little current yield.

Investing with an eye to inflation So what are the best investments in an inflationary environment? For inflation protection that is more or less a sure thing, many investors turn to Treasury Inflation-Protected Securities (TIPS). TIPS ensure a return that keeps up with the inflation rate as measured by the CPI. When inflation is mild, however, these returns will be modest. Fixed-income investors who need higher returns may do well to consider a global bond or multisector fund which may be able to take advantage of non-U.S. interest rates, currencies and yield curves.

Even though stocks and bonds may not thrive in an inflationary environment, some companies and issuers will do better than others. This may be a case when an experienced equity or fixed-income fund manager can add significant value. Investors concerned about inflation may also want to explore commodity, real estate or alternative investments. Figure 5 shows the performance of different types of assets during historical periods of inflation.

Commodities can benefit from rising inflation

U.S. dollar-based commodities are linked directly to overall price levels and should appreciate as the value of the dollar falls. As demand for raw goods increases, producers and suppliers demand higher prices to offset dollar devaluation. Base metals such as copper and steel may benefit in an inflationary environment, but gold is the best-known inflation hedge.

tHe eFFects oF inFlation and rising rates on Fixed-income securities

High quality (U.S. Treasury and agency)

• Longer maturity/duration investments fall in value • Shorter maturity/duration investments fall less Treasury Inflation-Protected

Securities (TIPS)

• Coupons and principal adjust with CPI • Higher inflation is offset by CPI adjustments

• Deflation reduces principal and interest, but maturity can be no less than par

Corporate-related (investment grade, high yield, bank loans, convertibles)

• May show mixed results, as they are also affected by corporate and economic fundamentals

• Floating-rate issues (bank loans) may adjust for higher interest rates

Non-dollar-denominated investments

• The value of the dollar may decline as inflation rises • Some USD depreciation may offset rising yields from

higher inflation

Economic growth & corporate fundamentals Inflation expectations Supply/Demand for borrowing (economy growth) TIPS

2%

5%

6%

Credit

Spread

Inflation

Premium

Real

Risk-Free

Rate

Figure 4: corporate bond yields include a premium For inFlation

This chart is for illustrative purposes only and is not intended to represent a specific bond. Percentages are based on historical averages.

Gold has historically served two purposes – as a hedge to inflation and as a store of value in bad times. The dramatic run-up in gold during the financial crisis and its aftermath is a good example of its resiliency. The effect of deflation on gold or other precious metals is less clear. In a bearish deflationary scenario, it is difficult to know if gold would rally as a “safe haven” or succumb to commodity-linked forces, which would cause its price to fall.

Real estate – still an inflation hedge? Both residential and commercial real estate are real assets that have historically provided inflation protection. But given the current state of these markets, historical relationships may not necessarily hold true. Property market fundamentals are likely to overshadow inflation or deflation concerns. Investors interested in maintaining exposure to real estate for diversification or income purposes may do well to invest in a REIT fund. Real estate investment trusts generally pay dividends, which may help offset other price declines, and generally invest in diversified portfolios of residential and commercial real estate securities. They also have daily liquidity, unlike actual property investments. It is important to keep in mind that REITs are still subject to the risks of the real estate industry, which can include fluctuating real estate values, changes in interest rates and property taxes, and the risk of mortgage defaults or mortgage prepayments.

Alternative investments

Again, with no significant inflation or deflation over the past few decades,

history can act only as a rough guide to investment performance. Today’s global economy, with its interlinked currency, commodity and futures markets, may offer new investment opportunities that didn’t exist the last time inflation heated up. Strategies now available in mutual funds may provide some insulation from the ravages of extreme inflation or deflation.

Alternatives are often defined as any investment that is not traditional, long-only equities or fixed-income. Alternative investments may have greater flexibility to benefit from changes in financial markets that have a negative impact on traditional investments. Some funds use strategies, such as the ability to hold

short positions, which increase in value when markets decline. Alternative mutual funds also may offer global exposure to non-traditional asset classes such as commodities, currencies and interest rates that can otherwise be difficult for investors to pursue on their own.

Other funds use absolute return strategies which may improve

diversification. Absolute return funds are managed independently of standardized benchmarks, which may help produce returns with lower correlations to traditional investments. And finally, some alternative mutual funds use quantitative techniques to manage risk, limit

volatility and avoid unwanted extremes in performance.

inFlation period

(6% or more year over year)

Oct. ‘40 – May ’42 Jun. ‘46 – Mar. ’47 Sep. ‘49 – Feb. ’51 Sep. ‘72 – Dec. ’74 Jan. ‘77 – Mar. ’80

Economic Growth Strong Negative Strong Weak Solid

Inflation Rate 16.0% 18.8% 8.2% 23.6% 37.6%

S&P 500 -13.5% -18.0% 61.1% -32.8% 12.4%

U.S. Small-Cap Stocks -0.9 -29.6 77.8 -45.6 92.3

LT Corp. Bonds 4.6 0.8 1.5 1.8 -15.5

LT Gov’t Bonds 6.3 1.1 0.7 4.7 -17.1

IT Gov’t Bonds 3.3 1.2 1.3 13.5 2.3

30-Day U.S. T-bills 0.1 0.3 1.8 17.2 28.0

Gold* 0% (approx) 0% (approx) +10% (approx) 174.3 267.7

GS Commodity Index N/A N/A N/A 191.7 75.6





Source: Morningstar Direct, Ibbotson Associates, St. Louis Fed.

*Approximate returns for spot gold prices from the World Gold Council. Cumulative returns for each period. Past performance is no guarantee of future results.

However, like all investment products these strategies are subject to certain risks. Many alternative strategies may have implied leverage (a small amount of money to make an investment of greater value), which may magnify any gains or losses on those investments.

A broader definition of diversification

Looking ahead, U.S. baby boomers transitioning to retirement and living on a fixed income are likely to gain new respect for even modest inflation. These investors in particular should be encouraged to make sure their allocations include:

• Equities, to keep pace with inflation – Actively managed funds, international stocks and emerging markets may have an edge.

• Global or multisector bond exposure – Overseas markets may offer better opportunities due to interest rate and currency variations.

• Alternative funds – Exposure to non-traditional strategies and asset classes, including commodities, may help hedge against inflation.

While inflation has been negligible for close to a generation, it will always be a risk factor to address in portfolio construction.

inFlation and portFolio

con-struction: tHe implications

• For INveSTmeNT FIrmS

Consider expanding platform offerings to include global bond, alternative and abso-lute return funds to help meet demand from financial advisors and their clients. • For FINaNCIal ProFeSSIoNalS

Keep in mind that 3% inflation is an 80-year average, and factor potential infla-tion spikes into asset allocainfla-tion strategies, particularly for income-oriented clients. • For INveSTorS

Remember that even modest inflation undermines spending power, which takes on added meaning when planning for retirement income. Make sure that you are talking to your advisor about your specific investment needs and goals.

glossary oF inFlation terms

Key terms Definition additional explanation

Hyperinflation Excessive inflation rate, over 100% annualized Usually associated with a currency collapse

Disinflation A falling, but still positive, rate of inflation Usually indicates an improvement in the economy

Deflation Falling prices Opposite of inflation

Stagflation Inflation without growth, or with stagnant growth The risk of stagflation may not be fully appreciated by investors

TIPS Treasury Inflation-Protected Securities Fixed-income securities whose principal and interest is pegged to

the inflation rate

CPI Consumer Price Index The broadest measure of price changes/inflation in the U.S.

Core CPI CPI excluding food and energy This measure has become the most widely used because food and

energy prices can be very volatile, and their excessive movement would unfairly bias the measure of inflation.

Natixis GLoBaL asset MaNaGeMeNt, s.a.

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services arm of Groupe BPCE. The firm ranks as one of the largest asset management companies in the world2 _{with more than 20}

investment managers in the U.S., Europe and Asia. NGAM’s multi-affiliate structure provides a single point of access to specialized professionals with unique insights and diverse approaches to investing. The firm’s hallmark is a consultative approach based on listening and understanding clients’ needs. It goes beyond products to create comprehensive investment solutions for institutions, intermediaries and individuals.

It’s called Better thinking. Together.® _{and it helps clients around the globe make the most of complex markets.}

1 As of September 30, 2012. Assets under management (AUM) may include assets for which non-regulatory AUM services are provided. Non-regulatory AUM includes assets which do not fall within the SEC’s definition of ‘regulatory AUM’ in Form ADV, Part 1.

2 Cerulli Quantitative Update: Global Markets 2012 ranked Natixis Global Asset Management, S.A. as the 13th largest asset manager in the world based on AUM as of December 31, 2011.