keepin’ it real - j.p. morgan · inflation-protected securities (tips) commodity prices tend to...

FOR INSTITUTIONAL AND PROFESSIONAL INVESTOR USE ONLY | NOT FOR RETAIL USE OR DISTRIBUTION

SUMMARY: Keepin’ it realInflation risk as an asset allocation problem

In a world of low yields and slow growth, inflation fears appear to have eased. But that doesn’t mean the need for managing inflation risk has passed. Regardless of one’s view on where inflation is heading, the most appropriate framework for addressing inflation risk is one that incorporates it as an ever-present risk—not a one-off shock. This paper, which summarizes key findings from the full paper, Keepin’ it real: Inflation risk as an asset allocation problem, explores the challenges of managing inflation risks across a variety of environments. J.P. Morgan Asset Management’s Global Multi-Asset Group (GMAG) looks at the historical

IN BRIEF• Individual assets behave differently depending on

the inflationary environment and, as a result, offer investors varying degrees of protection.

• Inflation risks must be understood in the context of the broader business cycle. The state of the economy can often be a key driver in the discussion around inflation risk.

• Inflation can affect investors and portfolios in many ways. Those with shorter time horizons or more regimented liquidity needs tend to be exposed to inflation to a greater degree than other longer term investors.

• The right diversified mix of assets is vital and can help deliver a premium over inflation with greater consistency than a more narrow and concentrated approach.

S U M M A R Y : Keepin’ it real

2 | Summary: Keepin’ it real: Inflation risk as an asset relocation problem

performance of individual assets and their effectiveness at managing inflation risks, depending on the level and direction of inflation, as well as the business and economic conditions. We also provide a framework for thinking about managing inflation risks in portfolios with a goal of achieving real returns regardless of the inflationary and economic environments.

Inflation risk: What are we really protecting against?

Inflation risk is really the risk that your portfolio will underperform inflation during the required time horizon, resulting in negative real returns. Investors with shorter time horizons, more regimented payout policies or those who have some inflation indexation in their cash flow requirements are most at risk of underperforming. If an investor has a long time horizon and can withstand volatility, then inflation may be less of an issue. Exhibit 1 shows the probability of various asset classes beating inflation over multiple rolling periods. As the time horizon approaches rolling 10-year periods, the frequency with which most of these assets have historically beaten inflation approaches 100%.

The first thing to note here is that the assets in the exhibit are not perfectly correlated with inflation. For some assets, such as commodities and direct real estate, the frequency of

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Source: Based on rolling monthly, quarterly and annual returns, January 1970 (or earliest available) through December 2011. Data sources include: Stocks—S&P 500 Index; Bonds—Citigroup US GBI All Maturities; REITs—NAREIT Equity Index; TIPS—Barclay Capital US TIPS Index and TIPS back-tested historical returns estimated from backfilled index; Commodities—DJ UBS Index; Private Real Estate—NCREIF Index; and Inflation—U.S. Headline CPI-Urban consumers.

EXHIBIT 1: PROBABILITY OF BEATING INFLATION OVER ROLLING PERIODS

beating inflation actually declined as the horizon extended, before resuming an upward course. Second, though all assets fall below 100% frequency in periods less than 10 years, we did not find a single time period in which all assets failed to beat inflation. In every time period, at least one asset achieved that goal. So investors with diversified portfolios will likely have at least one asset beating inflation. And finally, simply measuring the frequency of the shortfall tells the investor nothing about magnitude. Even periods in which an asset or portfolio shows a high frequency of beating inflation, or in the rare period where it fails to beat inflation, the shortfall could still be extreme and dangerous.

What this data shows us is that those who are most exposed to the risk of inflation are those with time horizons or distribution requirements that are within 10 years. For those investors, a diversified solution is best.

Inflation as a cyclical riskWe believe managing inflation risks starts by understanding how inflation conditions change over time. Empirical evidence suggests that the inflation cycle has historically consisted of alternating small episodic movements of increasing or decreasing inflation (or cyclical risks), marked by sporadic, larger regime shifts—ranging from prolonged periods of moderate inflation, to periods of extreme and volatile inflation. Exhibit 2 illustrates four types of inflationary regimes in the U.S., as measured by headline CPI inflation from 1970 through 2011: low and rising inflation; high and rising inflation; high and falling inflation; and low and falling inflation.

In the chart, we see that inflation spikes—when inflation spiked well above 4%—are relatively rare. The far more common scenario, accounting for approximately 60% of inflationary episodes, was a short period in which the increase in inflation was moderate and then corrected relatively quickly.

We should note here that one approach to understanding inflation focuses on its super-cyclical (or secular) tendencies—regimes lasting a decade or longer. In recent history, such regimes have featured long cycles of relatively contained inflation, with smaller cycles moving in a tight range. There also have been extended periods, such as the 1970s through the early 1980s, when inflation was very volatile and spiked to significant levels before falling. Not only does the volatility of

J.P. Morgan Asset Management | 3

inflation change over time, the causes of inflation in these super cycles also change.

The threat of inflation also must be viewed holistically in terms of how it may interact with other risks, such as business cycles—which are not always correlated with inflation cycles. Exhibit 3 shows the percentage of monthly periods since 1970 in which the business cycle was in an expansion or recovery, compared with periods in contraction or recession. We see that the frequency of these periods, in aggregate, is nearly identical.

While inflation shocks are rare, recessions and contractions are not. So in those frequent sustained periods of contained inflation (<4%), there still remains a strong possibility of encountering the downdraft of a business contraction or recession. Data indicate that the most common inflation risk scenario is a period of low inflation combined with a bear (or falling) market, which could result in negative real returns for investors.

Investors also need to be concerned with the broader observation that inflation does not exist in a vacuum. Inflation

risk must be understood holistically in terms of how it may interact with other risks. Even if investors address the narrow risk of inflation spikes that does not imply that they have also addressed the larger issue of negative real returns due to bear markets and downdrafts in the broader business cycle. That is why diversification is essential. One cannot know in advance what other risks will appear together with inflation, potentially magnifying its dangers.

Thus, managing inflation risks is, in and of itself, incomplete. Likewise, protecting portfolios from business cycle risks alone is also incomplete. Striking a balance between these forces when approaching portfolio construction may significantly improve risk-adjusted performance through a wider range of possible market scenarios.

Performance of assets in different inflationary environmentsOne of the key tenets to managing inflation risk is to understand that individual assets do not perform the same way in all inflationary environments. Returns vary depending on the level and direction of inflation and can often be driven by independent and unpredictable factors, such as asset bubbles, seasonal changes, sector weighting changes or changes in the business cycle. These cycles can occur in connection with, or independent of, inflation cycles, which can cause the asset returns to behave differently from one inflationary environment to another. Relying too heavily on historical asset class performance records, or the past

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EXHIBIT 2: U.S. INFLATION BY REGIME

Source: J.P. Morgan Asset Management’s GMAG analysis. Data from January 1970 through December 2011. CPI headline inflation year-on-year change, Bureau of Labor Statistics. Threshold level between high and low inflation is set at 4%; rising (falling) is defined as the current year-on-year change greater than (less than) the year-on-year change three months prior.

EXHIBIT 3: INFLATION VS. BUSINESS CYCLE

Source: IP growth and inflation are shown as an average annualized year-on-year percentage change for U.S. Industrial Production and U.S. Headline CPI, respectively, over the relevant periods from 1970 through December 2011.

Business cycle Recovery Expansion Contraction Recession

Avg. IP growth rate (%) -4.2 4.6 4.0 -5.2

Avg. inflation rate (%) 4.9 3.6 4.6 6.3

% of months since 1970 (%) 8.0 42.0 37.0 13.0



risks, what we can learn from this analysis is how to balance assets against each other’s trends and potentially use them together to manage inflation risks in portfolios. Understanding which assets lead or lag inflation can lead to more robust portfolios.

A closer look at commodities and Treasury Inflation-Protected Securities (TIPS)Commodity prices tend to lead inflation when it is rising because they are a core component, and sometimes even a driver, of inflation. As Exhibit 4C shows, commodities usually generate their strongest returns in high and rising inflationary periods. But commodity returns can quickly turn negative when inflation is high (above 4%) and falling. Commodities are

behaviors of inflation itself, can yield inappropriately narrow strategies that fail to anticipate inflation’s wide variability.

We can identify four phases of the inflation cycle and how those phases relate to the broader business cycle. The four inflationary conditions are: 1) high (or above 4%) and rising; 2) high (or above 4%) and falling; 3) low (or below 4%) and rising; or 4) low (or below 4%) and falling.

Exhibits 4A–4D demonstrate some underlying trends in asset returns when inflation changes, but the charts also highlight a bigger conclusion—there is no single asset that is perfectly sensitive to inflation. Comparing volatile asset returns with inflation clearly leaves a lot of noise since inflation is only one small component of what drives markets. While there is no single asset that will perfectly insulate investors from inflation

EXHIBITS 4A–4D: PERFORMANCE OF ASSETS ACROSS FOUR INFLATIONARY ENVIRONMENTS

Source: J.P. Morgan Global Multi-Asset Group. Inflation-sensitive equities based on HSBC Gold Metal and Mining Index; REITs based on MS REITs Index; TIPS based on BarCap US TIPS Index (since a TIPS index was not introduced until 1997, returns before then are based on a simulated history of pre-1997 TIPS returns); and Commodities based on GSCI. Diversified inflation portfolio results are based on analysis derived from J.P. Morgan Asset Management long-term capital market return assumptions and strategic asset allocations as of December 2011. All returns monthly from January 1971 (or earliest available) to December 2011. High inflation determined by YOY Headline CPI greater than 4.0%. Rising inflation defined as YOY CPI greater than prior 3 months.

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4B: LOW AND FALLING INFLATION (33% OF THE TIME)

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4D: HIGH AND FALLING INFLATION (20% OF THE TIME)


also highly sensitive to the business cycle. They continue to perform well even as the economy contracts, but can quickly turn negative as the economy moves into recession (Exhibit 5). Commodities tend to lag the business cycle and remain negative even as other assets rebound in anticipation of a recovery. Given their sensitivity to different environments, commodities are highly volatile, and their best- and worst-performing periods can be just months apart. Investors who invest in commodities halfway into an “up cycle” could find themselves trapped in those positions with no exit as the cycle quickly reverses. And in a perfect-storm scenario—when high and falling inflation coincides with a recession—commodity investors could face significant losses.

Meanwhile, TIPS, which are bonds that are structurally linked to inflation as they offer a fixed coupon and principal value that adjusts with changes in the CPI, generally have strong correlation with inflation in times of low to moderate inflation. Returns improve when inflation is low and rising—and still offer some protection to changes in inflation when the inflation rate is above 4% (Exhibits 4A, 4C). However, when inflation is low and falling (or there is a deflationary period), TIPS will see a deterioration in performance. While the protection offered by TIPS can be valuable in times of rising inflation, they can subject the portfolio to sizeable carrying costs when inflation is low. Since the majority of returns of TIPS come from nominal yield, when there is no inflation, the added premium investors pay to get inflation protection limits their returns. Meanwhile, a TIPS portfolio also is exposed to business cycle risk with performance generally underperforming other assets in recessions and recoveries (Exhibit 5).

Each inflation-sensitive asset class will have its own unique relationship with the business and inflation cycles. It is

important to not only understand the risks inherent in these relationships, but to diversify across the spectrum of inflation-sensitive asset classes to ensure consistent performance across the different cyclical environments. (For more analysis on specific asset classes, contact your J.P. Morgan representative or refer to the full paper, Keepin’ it real: Inflation risk as an asset allocation problem, which is available at jpmorgan.com/assetmanagement.)

Portfolio construction: Seeking robust inflation protectionManaging inflation risks should be a core component of the portfolio modeling and construction process. When considering inflation protection, the goal of investors should be to identify and implement a robust diversified solution that addresses both sides of the risk/return equation. We see five key factors that influence that goal.

Time horizon of inflationHistorical analysis indicates that all asset classes have beaten inflation over periods longer than 10 years, but no single strategy will work in all scenarios over shorter time horizons. Combining asset classes into diversified portfolios may shorten this time horizon, but a conservative view would set the outer boundary of inflation sensitivity at 10 years. As a result, investors with shorter term or opportunistic views on inflation risk, or DC plan participants, particularly those close to retirement, should begin to factor inflation risk into their portfolio at least 10 years before any liquidity is required from the portfolio.

Volatility toleranceConstructing a portfolio with a constrained approach to volatility can help deliver a premium over inflation with greater consistency than an approach that focuses more exclusively on inflation-sensitive assets. This constrained volatility approach helps address the most common type of negative real returns that occurs in low inflation and bear market environments. By mitigating the risk of big drawdown events in these periods, the goal of achieving a premium over inflation over the medium term, or over a market cycle, becomes much more realistic. While adding assets with higher levels of volatility can increase expected returns, they also come at a price—more portfolio volatility and a decreased

EXHIBIT 5: AVERAGE ANNUALIZED HISTORICAL RETURNS ACROSS BUSINESS CYCLES FROM 1970 (OR EARLIEST AVAILABLE) THROUGH DECEMBER 2011

Sources: Average annualized historical returns from 1970 (or earliest available) through December 2011. TIPS: Barclays Capital Inflation Linked Index and TIPS back-tested historical returns estimated from backfilled index (since a TIPS index was not introduced until 1997, returns before then are based on a simulated history of pre-1997 TIPS returns); Commodities: Goldman Sachs Commodities Index (GSCI); Inflation-sensitive Equities: HSBC Mining Gold & Energy Index; and REITs: NAREIT Equity Index.

(%) Recovery Expansion Contraction Recession

TIPS 12.0 8.9 9.7 9.4

Commodities 14.6 15.4 15.7 -15.8

Inflation-sensitive Equities 28.3 11.1 11.9 6.7

REITs 24.5 11.0 13.1 8.6



Liquidity constraintsCertain assets, such as direct real estate, may provide robust inflation protection, but also may compromise other portfolio objectives such as liquidity. As withdrawals increase, large positions in illiquid assets can compromise a portfolio’s ability to meet cash flow demands. Investors need to strike a balance between exposing their portfolios to less liquid assets in a meaningful enough way so as to provide some inflation sensitivity, while still giving them the ability to manage, rebalance and diversify their portfolios.

Investor riskDifferent types of investors have varying degrees of exposure to inflation risks. Those who are most at risk include:

• DC plan participants and investors saving for retirement, particularly those at or near retirement, who are at risk of deteriorating purchasing power

• Endowments and foundations with specific annual spending targets

likelihood that the portfolio will meet its investment targets. Investors must assess the use of potentially volatile assets in portfolios to strike the correct balance between portfolio volatility and efficient risk-adjusted returns.

Return trade-offsIn addition to the costs in periods of high volatility, inflation protection can impose portfolio costs in terms of lower growth. For example, TIPS can be thought of as an insurance policy against rising inflation. Although TIPS can be useful for a portfolio in certain environments, in times of contained inflation—which are more common than inflationary shocks or spikes—investors are paying a premium for that protection in the form of returns that underperform other fixed income and inflation-sensitive investments. As a result, investors need to think carefully about striking an effective balance between protecting against negative real returns and meeting growth targets. How much inflation protection is really needed, and how much growth can the portfolio afford to give up to get such protection?

Source: J.P. Morgan Capital Market Assumptions (see note below). Historical returns represent index return data for all asset classes. Data as of January 2012. Note: The projections in the charts are based on J.P. Morgan Asset Management’s (JPMAM) proprietary long-term capital markets assumptions (10-15 years) for risk, return and correlations between major asset classes. The resulting projections include only the benchmark return associated with the portfolio and do not include alpha from the underlying product strategies within each asset class. The assumptions are presented for illustrative purposes only. They must not be used, or relied upon, to make investment decisions. The assumptions are not meant to be a representation of, nor should they be interpreted as, JPMAM investment recommendations. Allocations, assumptions and ex-pected returns are not meant to represent JPMAM performance. Please note all information shown is based on assumptions, therefore, exclusive reliance on these assumptions is incomplete and not advised. The individual asset class assumptions are not a promise of future performance. Note that these asset class assumptions are passive-only; they do not consider the impact of active management. Given the complex risk/reward trade-offs involved, we advise clients to rely on judgment as well as quantitative optimization approaches in setting strategic allocations to all the above asset classes. Please note that all information shown is based on qualitative analysis. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular asset class or as a promise of future performance. Note that these asset class assumptions are passive only—they do not consider the impact of active management. References to future returns for either asset allocation strategies or asset classes are not promises or even estimates of actual returns a client portfolio may achieve.

EXHIBIT 6: EXPECTED PORTFOLIO RETURNS ASSOCIATED WITH DIFFERENT LEVELS OF RISKY ASSETS

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• Public DB plans with cost-of-living adjustments built into liabilities

• Other investors with shorter term or opportunistic views on inflation risks

Those who are most at risk of underperforming inflation are those with shorter time horizons, more regimented payout policies or who have some inflation indexation in their cash flow requirements. Therefore, it makes sense to constrain risk budgets reflecting the limited appetite for volatility and/or large drawdowns.

In the context of portfolio construction, incorporating a diversified mix of inflation-sensitive assets is best suited to delivering long-term, risk-adjusted real returns—regardless of inflationary conditions. As shown in Exhibit 6, focusing on the portfolio’s long-term growth as well as consistency of return should serve investors well in the medium and longer terms. The chart shows the expected returns associated with different levels of higher volatility assets and the probability of achieving CPI plus 3% over five years. Higher volatility assets are typically REITs, commodities and inflation-sensitive equities, while lower volatility assets are generally cash and inflation-sensitive fixed income. The highlighted box indicates the mix of portfolio assets that is most likely to deliver a premium over inflation over a market cycle while still mitigating the risk of large drawdown events that can be so detrimental to the portfolios of investors with shorter time horizons or regimented payout schedules.

ConclusionAs we have seen, there are no clear and easy solutions to protecting portfolios against inflation risks. Just because a particular inflation-protection strategy worked in one scenario doesn’t mean it will work again in the next environment. Each strategy also may impose additional costs or trade-offs. In order to develop the most prudent investment defense, investors need to understand how inflation-sensitive assets are likely to perform across a variety of circumstances and environments and choose inflation-sensitive strategies based on their own specific goals and challenges. One of the key takeaways is that a well-diversified, low-volatility portfolio of inflation-sensitive assets can provide effective protection across multiple inflationary and economic scenarios—while helping to minimize drawdown risks and potential negative real returns.

This summary highlights key findings from the paper, Keepin’ it real: Inflation risk as an asset allocation problem, which aims to provide a holistic approach to managing inflation risk in all its forms. For more information, contact your J.P. Morgan representative or refer to the full paper, which is available at jpmorgan.com/assetmanagement.


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FOR INSTITUTIONAL AND PROFESSIONAL INVESTOR USE ONLY | NOT FOR RETAIL USE OR DISTRIBUTION

IMPORTANT DISCLAIMER

FOR PROFESSIONAL INVESTORS ONLY—NOT FOR RETAIL USE OR DISTRIBUTION. ‘PROFESSIONAL INVESTOR’ MEANS THE DEFINITION ASCRIBED TO IT WITHIN THE EUROPEAN UNION DIRECTIVE 2004/39/EU ON MARKETS IN FINANCIAL INSTRUMENTS (MiFID).

This material is intended to report solely on the investment strategies and opportunities identified by J.P. Morgan Asset Management. Additional information is available upon request. Information herein is believed to be reliable but J.P. Morgan Asset Management does not warrant its completeness or accuracy. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan Asset Management and/or its affiliates and employees may hold a position or act as market maker in the financial instruments of any issuer discussed herein or act as underwriter, placement agent, advisor or lender to such issuer. The investments and strategies discussed herein may not be suitable for all investors. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Changes in rates of exchange may have an adverse effect on the value, price or income of investments.

All case studies are shown for illustrative purposes only and should not be relied upon as advice or interpreted as a recommendation. Results shown are not meant to be representative of actual investment results. Any securities mentioned throughout the presentation are shown for illustrative purposes only and should not be interpreted as recommendations to buy or sell. A full list of firm recommendations for the past year is available upon request.

Asset allocation/diversification does not guarantee investment returns and does not eliminate the risk of loss.

J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited, which is regulated by the Financial Services Authority; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l. Issued in Switzerland by J.P. Morgan (Suisse) SA, which is regulated by the Swiss Financial Market Supervisory Authority FINMA; in Hong Kong by JF Asset Management Limited, JPMorgan Funds (Asia) Limited or JPMorgan Asset Management Real Assets (Asia) Limited, all of which are regulated by the Securities and Futures Commission; in Singapore by JPMorgan Asset Management (Singapore) Limited, which is regulated by the Monetary Authority of Singapore; in Japan by JPMorgan Securities Japan Limited, which is regulated by the Financial Services Agency; in Australia by JPMorgan Asset Management (Australia) Limited, which is regulated by the Australian Securities and Investments Commission; and in the United States by J.P. Morgan Investment Management Inc., which is regulated by the Securities and Exchange Commission. Accordingly this document should not be circulated or presented to persons other than to professional, institutional or wholesale investors as defined in the relevant local regulations. The value of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

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AUTHORS

Maddi Dessner, CFAClient Portfolio ManagementExecutive [email protected]

Katherine Santiago, CFAResearch and Analytics Vice [email protected]

Joseph Simonian, Ph.D.Research and Analytics Vice [email protected]

Michael Albrecht Analyst

Albert ChuangAnalyst

Michael Feser, CFAManaging Director

Rebecca Hellerstein, Ph.D. Executive Director

Grace Koo, Ph.D.Vice President

Beth LiAssociate

Victor Li, Ph.D.Associate

Yazann Romahi, Ph.D., CFAExecutive Director

Katherine Santiago, CFAVice President

David ShairpManaging Director

Abdullah Sheikh, FSAVice President

Joseph Simonian, Ph.D.Vice President

Jeff SunAnalyst

GMAG Research and Analytics Team

We would like to thank Caitlin Gerdes, Analyst, GMAG, for helpful feedback and editorial assistance with this paper.

Michael Albrecht Analyst

Albert ChuangAnalyst

Michael Feser, CFAManaging Director

Rebecca Hellerstein, Ph.D. Executive Director

Grace Koo, Ph.D.Vice President

Beth LiAssociate

Victor Li, Ph.D.Associate

Yazann Romahi, Ph.D., CFAExecutive Director

Katherine Santiago, CFAVice President

David ShairpManaging Director

Abdullah Sheikh, FSAVice President

Joseph Simonian, Ph.D.Vice President

Jeff SunAnalyst

GMAG Research and Analytics Team

We would like to thank Caitlin Gerdes, Analyst, GMAG, for helpful feedback and editorial assistance with this paper.

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