With global macroeconomic pressures not abating any time soon, and inflation signals coming in higher than expected, many advisors and investors are seeking guidance on how to amplify inflation protection within their portfolio. Recently, Matthew Bartolini, global head of research strategists at State Street Investment Management, sat down with VettaFi to discuss where inflation stands, opportunities within portfolio construction, and much more.A State of Play on InflationNick Wodeshick: Ever since all this geopolitical unrest started kicking up in March, we’re increasingly seeing folks that are worried how subsequent inflation is going to affect their portfolio. And April’s CPI numbers coming in higher than expected certainly aren’t going to abate any of these concerns. So, to get things started, how are you and your team looking at the April CPI report? Is this just another bump in the road, or should investors start considering fundamental changes in their portfolio construction?
Matthew Bartolini: I don’t think it’s a bump in the road as much as an illustration of a retransformed macro backdrop, where inflation has become a much more of a durable risk factor impacting traditional portfolios. And that’s largely a result of a couple aspects.
One being that many portfolios today are heavily concentrated in equities, namely U.S. equities. But concentrated in equities and then also nominal bonds with something like the Agg, which has treasuries and then some credit to it as well. And credit is a native asset class of fixed income as well, so it inherits some of the nominal bond properties.
Equities and nominal bonds do not really like rising inflation. And so, a traditional portfolio is not really prepared for more stubborn inflation, but also more inflation volatility in terms of inflation expectations. Breakeven rates have been quite volatile, and it’s just because of the push and pull dynamics of our macro backdrop, which have become more complex and more uncertain.The CPI ReportMatthew Bartolini: I think with the CPI report, or even the PPI report which came out yesterday, a lot of folks might just sort of dismiss those reports where energy is the sizable catalyst. And the spot rise and spot price of the energy does weigh on it. But if we look at something like the Supercore CPI, which strips out housing and energy, because again, someone could point to the CPI number and be like, ‘well, you had that statistical quirk of the housing numbers because of the shutdown’.
But if you take the Supercore, which strips out housing and energy — the two things that the naysayers might glom onto — well, you have Supercore continuing its upward trend. It’s now well above 3%. And you juxtapose that with even slower moving measures of CPI like the Fed Sticky CPI that’s over 3%, or a Sticky CPI less Shelter that’s around 3%, but all of them are moving higher because of these more structural aspects of inflationary systems.
See more: Materials Sector Rebounds: Why XLB is Surging in AprilThe AI CapEx EffectMatthew Bartolini: Tariffs have proven to be inflationary in this market environment. You’ve seen significant supply chain reconfiguration, but you also have this non-transitory effect starting to emerge with the rise of AI CapEx. So, with all of these capital expenditures coming into the marketplace — for building out the infrastructure, the memory chips — it is having an impact of an intensifying competition for critical inputs. And you’re seeing a near-term inflation impulse to that now where that is an immediate impulse in the sort of productivity miracle deflationary impacts. Those are much further out on the horizon.
So, there’s a timing effect to the AI CapEx build out and its inflationary aspects. And of course, you see PPI numbers reflecting this in the upstream data: manufacturing components and process materials for PPI finished goods are rising. They rose the highest since 2022.
You also see ISM numbers coming out for prices paid, and that number is at the highest since, I think, 2022 as well. And I think that is just evidence of the continued cost pressures across different productions. So, it is definitely not a bump in the road.
We’re marking an inflection point, where the complexities of our macro backdrop — where we move from globalization to deglobalization, from cooperation to fragmentation — are having really important impacts on inflationary dynamics. And a lot of traditional portfolios are not sufficiently balanced or have a sufficient amount of resilience in their portfolio to adjust to a new inflation paradigm.The Movement Towards Inflation-Protected BondsNick Wodeshick: On the topic of portfolio construction- considering how many folks are worried about both inflation and covering portfolio risk via income, it’s not a shock to hear that investors are increasingly pivoting towards inflation-protected bonds. State Street is no stranger to this universe – offering multiple funds, including the State Street SPDR Portfolio TIPS ETF (SPIP A) and the State Street SPDR FTSE International Government Inflation-Protected Bond ETF (WIP A+). Are you viewing these kinds of strategies as especially attractive choices in today’s environment, and are there any State Street inflation-protected bond funds in particular that you would want to highlight?
Matthew Bartolini: We also have (TIPX B+), which is a one- to ten-year inflation protected bond ETF. And I think TIPX is actually kind of more interesting one, because it’s one- to ten-year, so it cuts off the tail in duration. That’s the other thing with inflation-linked bond ETFs: while they like rising inflation because inflation-linked bond ETFs accrue the rate of inflation, you’re accruing that inflation premium over time.
They’re still bonds. They still inherit the native risk sensitivities of bonds. If this higher inflation then leads to higher rates to sort of control that inflation, or term premiums rise for investors needing to be compensated for bearing that inflationary risk, TIPS can still have a negative return. So, they might allow you to accrue a higher inflation premium at a time period of higher and more stubborn inflation risks, but there is still that risk that the bond portion of it leads to duration-induced price declines.Beyond the Inflation-Linked BondMatthew Bartolini: One way to maybe mitigate that is to cut off that longer tail of the duration curve of inflation-linked bonds and use something like TIPX. And of course, we’ve seen long-term rates back up a bit and we’ve seen TIPX outperform SPIP. So, one- to ten-year outperforming broad year-to-date as a result of that. That’s just something to have in consideration when thinking about what you’re trying to do within your portfolio and the risks that you’re also including.
Because if you just go out and add inflation-linked bonds, you’re adding duration. If you buy inflation-linked bonds and sell your treasuries exposure, now you may be duration matched and so you’re not taking on any more duration. And when we think about this idea of inflation resilience, and maybe this is where you’re going next, we think about inflation-linked bonds as one aspect of it. We think there’s other ways to derive or construct a more resilient and balanced portfolio to mitigate the inflationary pressures that are hitting multiple parts of the economy.
See more: Why the Healthcare Sector Warrants Concentrated ExposureWhy Consider Commodities?Nick Wodeshick: We’re seeing hundreds of millions of dollars already flow into broad commodity ETFs in May. Now, why do you think this is primarily happening — is it because of inflation, because people still want to hedge against currencies, or because they’re looking to capitalize on supply-chain disruptions? Or is it just some combination of the above?
Matthew Bartolini: It’s the rise in spot prices of commodities due to critical choke points being impacted. Notably the Strait of Hormuz, and the supply chain reconfiguration that was significantly kicked off around Liberation Day of last year. And that has caused rising commodity prices across multiple commodity contracts and sectors, and with rising prices, that has an impulse to inflation. And historically commodities have a strong correlation to rising inflation dynamics. So, it’s just a manifestation of all of those macro touch points: supply chain reconfiguration, choke points being weaponized that then lead to rising spot prices, and then the pull through to inflation dynamics. And the end result is investors gravitating towards an asset class that has a positive reaction function to those.The Future of the 60/40 Portfolio in an Inflationary RegimeNick Wodeshick: So, in a world where “hotter-than-expected” inflation continues to stick around, does the traditional 60/40 portfolio continue to do its job well? Or do those ratios need to be tweaked to properly account for what’s actually going on right now?
Matthew Bartolini: I think they need to be reexamined. I think the 60/40 portfolio, for all of its longevity, is largely a Goldilocks portfolio. It does well in rising growth and falling inflation. That’s an environment that we’ve largely been in over the last 15 to 20 years, where you had benign inflation up until the realignment of trade policies and the sort of post-COVID macro shocks. Again, that’s a supply chain reconfiguration dynamic as well.
I think that’s ultimately started to change, given the retransformation of the macro backdrop. I mean, non-U.S. equities are outperforming U.S. equities by and large this year, and they did last year as well. Those need to be readjusted to help infuse more resilience and balance, and diversify differently amid a more complex and uncertain macro backdrop.
And that’s why when we’re having conversations around portfolio construction or how to think about portfolio construction in this new macro paradigm, is that thinking about the way you’re exposed to those different economic environments. Do you have assets that respond positively to following growth and rising inflation?Putting Inflation-Resilience Into PlayMatthew Bartolini: In a lot of our conversations, from a product perspective, we start with (ALLW ) from Bridgewater, because it has that embedded bias of inflation resilience with commodities, with gold, with inflation-related bonds, that dedicated bias. And then that allows us to then move sort of directionally to say, well, if you don’t want that all multi-asset allocation yourselves, you can move down to something that is a blended real return fund like (RLY A+).
And to me, as I have said in some mediums, RLY is sort of the seafood tower of inflation resilience. It has inflation-linked bonds, natural resource equities, commodities, and real estate. It gives you a more blended approach because not one real asset that on its own can be a proven mitigant to inflation. There’s diversification on it, and then if you want to get more specific, you can go into commodities and then into gold.
Taking it from that lens and then you look at all of those assets that I just talked about, when you break down the global mutual fund and ETF asset base, there’s only like 2.3% of your fixed income total assets are in inflation-linked exposures. The majority of the assets, there is 65% in equities. So, something needs to be reexamined, and I think this is showcasing a renaissance of resilience and the need for balance in this marketplace.
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