Commentary
July 2013
Inflation Risk—How „Real‟ Is It?
By: Scott Gives, CFA, Senior Portfolio Manager, Fixed Income Team
The great inflation debate rages on and there are cogent arguments on both sides of the issue.
While difficult to measure and even harder to predict, inflation can erode an investor‟s wealth over time.
Well-designed inflation hedges, such as real return bonds, are an appropriate component of many types of portfolios.
Why should investors care? Because inflation gradually (or
suddenly, if it is uncontrolled) eats away at the purchasing
power of financial wealth. For example, in the last 20
years, inflation has averaged 1.84% on an annualized
basis. While that may not look like a big number, it implies
a significant loss of purchasing power over any meaningful
investment horizon: 20% over 10 years, 31% over 15
years, and 44% over 20 years. While we can‟t assume that
history will always repeat (or even rhyme), prudent
investors should still be attentive to such a clear and
pervasive risk to their assets and future well being.
© 2013
Annual Inflation excluding Food and Energy
Energy
30%
20%
10%
0%
-10%
2010
2007
2004
2001
1998
1995
1992
1989
1986
1983
1980
1977
-20%
1974
Measuring the general price level, much less periodic
changes in it, is notoriously difficult. Economists are able
to employ any of several methods, all of which can lead to
different results. Official inflation statistics are best thought
of as a rough estimate rather than a precise measurement
of changes in overall prices.
Exhibit 1: Inflation in Canada Since 1962
1971
Traditionally, the term inflation referred to an excessive
expansion of the money supply. This would undermine the
relative value of money, in accordance with the age-old
laws of supply and demand, and generally higher prices
would result. Today, the term inflation is typically used to
describe an overall rise in prices, regardless of the
monetary dynamics at work.
No point in recent history is more synonymous with
inflation than what most countries experienced in the
1970s and early 1980s. While inflation, as measured by
the Consumer Price Index (CPI), has been relatively
benign since then (core CPI, which excludes volatile food
and energy prices, has not exceeded 5.0% since 1983),
the term still strikes fear into the hearts of many
consumers and savers old enough to remember that
period. There is plenty of disagreement over what caused
and what ended the inflation of that era. But most would
agree that its psychological effects remain with us.
1968
What is Inflation, Anyways?
Some (Relatively) Recent History
1965
One of the most strident economic debates of recent years
relates to inflation. After years of low interest rates and
unprecedented monetary easing by many of the world‟s
major central banks, some market participants believe we
risk unleashing the inflation genie at some point in the
future. Others are far more sanguine, and there are
interesting arguments on both sides. Investors will
probably be best served by looking past the academic
arguments and focusing on the beneficial role that
inflation-protected securities can play in a portfolio.
1962



Source: OECD
Year-over-year change in Core Consumer Price Index and Energy Price
Index, 1962-2012; Energy Price Index consists of electricity, gas and
other fuels.
Since a good portion of our population experienced that
period, it frames our perception of what inflation is and
how it can affect our lives. For consumers, it was an
environment where wages lagged the cost of living. For
Canada, it was also a period of political turmoil, as the
sharp rise in energy prices had widely varying impacts on
different provinces and levels of government.
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Is There an Imminent Inflation Threat?
liquidity will not translate into lending. As a result, sluggish
credit creation globally has kept a lid on overall demand
and price pressures. As long as this persists, inflation is
likely to remain at tolerable levels. Of course, some
inflation hawks are quick to point out that, should demand
pick up significantly, many countries could find themselves
on top of an inflationary tinder box.
The fear of high inflation rearing its head depends heavily
on your perspective, including how you view the 1970s
episodes. There are a number of scholars who believe the
inflation of that period was caused by excessive deficit
spending
by
central
governments
and
overly
accommodative central banks. If that recipe sounds
familiar, it should—since the global financial crisis of 2008,
governments and central banks have been highly
accommodative in the pursuit of stronger economic growth
(see Exhibit 2, for example). From this point of view, the
classic ingredients for significant inflation are already in
place.
Still, not all scholars agree that the double-digit inflation of
the 1970s and early 1980s was caused by government
and central bank largesse. A compelling case can also be
made that the wild price volatility of that era was caused by
oil-price and energy-supply shocks that occurred after the
Organization of the Petroleum Exporting Countries
(OPEC) became the key producer, and by extension, the
ultimate price setter, in the oil patch. At that time,
developed economies were far less efficient in the use of
energy, and oil was a significant economic input with no
readily available substitutes. As a result, the oil shocks of
1973-1974 and 1979-1980, shown in Exhibit 3, had
dramatic impacts on many countries‟ price levels.
9
8
7
6
5
4
3
2
1
0
Exhibit 3: Crude Oil Prices, 1960-1995
90
1980 - Start of Iran-Iraq War
80
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Percent, Annualized
Exhibit 2: Bank of Canada Discount Rate
Price per barrel, 2005 U.S. dollars
1979 - Political upheaval in Iran
Source: International Monetary Fund
The problem with this view is that despite the pronounced
expansion in the supply of central-government liabilities,
we have yet to see a general increase in prices at an
aggregate global level. In fact, inflation has remained quite
tame, and some policymakers have expressed concern
over deflation, or a general decline in prices. There are
several factors that could explain the low inflation figures
we‟re seeing. First, for countries at the epicenter of the
2008 financial crisis, the severity of the ensuing recession
went well beyond any economic pullback since the Great
Depression of the 1930s. Second, the depth and severity
of the recession left significant slack in the labor markets
of many developed countries, as evidenced by lingering
unemployment and underemployment. This has kept wage
growth at low levels, and with labor costs such a large
component of the production process, goods prices have
not been pushed up significantly. Many nations are still
experiencing jobless recoveries, and as such, labor costs
are unlikely to put much pressure on overall prices for the
foreseeable future.
60
50
40
30
20
1973-74 - Second oil embargo
1973 - OPEC starts setting price
Before 1973, the West TX
Railroad Commission sets
the global price for crude oil.
10
0
1960
1965
1970
1975
1980
1985
1990
1995
Sources: Dow Jones & Co., U.S. Department of Commerce, SEI
Monthly spot price of West Texas Crude Intermediate adjusted by U.S.
GDP Implicit Price Deflator
Canada found itself in a rather interesting and difficult
position as a result of the oil-price boom. Unlike eastern
Canada and the U.S., which were net importers of oil,
western Canadian provinces benefited from rising oil
prices. As a result, Ottawa and Alberta became primary
combatants in a decade-plus battle over national and
provincial energy policies; the conflict was complicated
even further by the sharp decline in oil prices that unfolded
in the 1980s. National intrigue aside, what the price-shock
theory of the 1970s demonstrates is that inflation risks can
arise from natural or manmade (e.g., political) shortages of
key economic inputs, just as readily as it does from overly
dovish central bank and fiscal policies.
Thus, the dovish view of inflation rests upon the fact that,
in a global economy that is still growing very sluggishly
and struggling with high unemployment, and in an
environment where households in many parts of the world
are attempting to repair their balance sheets, consumers
and businesses are more prone to save Central banks
may pump as much financial liquidity as they choose, but if
banks face a shortage of worthy borrowers, and
businesses experience slow or stagnant demand, that
© 2013 SEI
Steep declines in energy
prices
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Have Inflation and Deflation Been Muzzled?
Given the compelling evidence on all sides of the inflation
debate, it might be worthwhile to see what other experts
are saying. A well-researched opinion was recently offered
by the International Monetary Fund (IMF) in its article, “The
.
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Dog that didn‟t Bark: Has Inflation been Muzzled or was it
Just Sleeping?” In the piece, the IMF made the following
observations:
Exhibit 4: Three-Month Changes in CPI
4%
3%
 Unemployment in many countries is at high levels that
would have been expected to cause severe deflation in
the past.
 However, in many developed countries, the sensitivity of
inflation to changes in unemployment has become quite
muted.
 Inflation expectations have become more stable since
the 1970s and 1980s. Sharp, short-term price-level
swings do not cause people to significantly change their
longer-term views of inflation.
2%
1%
0%
-1%
-2%
1955
1958
1961
1964
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
2012
-3%
Sources: OECD, SEI
Rolling three-month change in CPI; smoothed line is 18-month average.
The authors argued that changes in the economy and in
social institutions have resulted in very different inflation
dynamics compared to past decades. However, they were
also quick to point out that the behavior of inflation could
change again in the future, and that there is always some
possibility of prevailing inflation expectations coming
unhinged.
There are some unique risks associated with RRBs, of
course. First, the nature of issuance over the years has
resulted in the Canadian RRB market having a much
higher duration relative to other Canadian market sectors.
This means that Canadian RRB‟s are quite sensitive to
changes in interest rates. For example, the S&P/TSX DEX
RRB Index reported a modified duration of 15.8 years vs.
14.3 for DEX Federal Long Bonds and 6.8 years for the
DEX Universe Index at the end of June 2013. Based on
rough math, it would suggest that if interest rates were to
suddenly increase uniformly across the yield curve by 100
basis points (1.0%), the RRB market has the potential to
suffer double digit losses. However, inflation would almost
certainly need to be rampant for such a scenario to occur;
and if it did, the embedded option on inflation within RRBs
would increase in value, providing a natural offset against
the rise in bond yields and heightened inflation
expectations.
Our View
Given Canadian inflation has remained persistently low, is
inflation risk even worth thinking about? We certainly
believe so. As already noted, inflation is tricky to define
and very difficult to measure, and there‟s plenty of
disagreement over its causes. But there is no
disagreement over the fact that it can eat away at a
portfolio‟s value over time. And that‟s a risk that prudent
investors must always be attentive to when designing or
selecting an appropriate investment strategy.
Since 1991, the Federal Government of Canada has
issued bonds linked to changes in the Canadian inflation
rate known as Real Return Bonds (RRB‟s). Today, the
Canadian RRB market remains dominated by Federal and
Provincial governments, but a handful of corporations have
also issued debt linked to Canadian inflation.
Second, in a deflationary environment (marked by a falling
CPI), coupon payments and principal would be adjusted
lower by the percentage change in CPI. This does not
necessarily mean that that an investor would lose money
on their holdings, but they would be paid a lesser amount
compared to their previous payments. If deflation were to
become persistent, RRB payments would be tapered
commensurate with deflationary changes (again, on a
three-month lag). Of course, given the lower payments, the
market value of the bonds would likely decline. However,
for over 20 years, the Bank of Canada‟s policy objective
has been an inflation target of 2%. Although there has
been some discussion in recent years of a lower target,
economists at the Bank have admitted that, “while the
prospective benefits of a lower inflation target look greater
1
than they did in 2006, so do the risks.” As long as the
Bank of Canada succeeds in fostering positive but
moderate inflation, RRBs are worth considering for
RRBs offer a unique sensitivity to inflation risk, as both the
coupon and the principal are adjusted for changes in the
inflation rate (on a three-month lagging basis). If inflation
rises, the coupon payments will increase by a similar
percentage change in the three-month lagging inflation
rate. Of course, the same math works in reverse. But given
inflation generally increases over longer time periods (see
Exhibit 4), the original principal value of the RRB‟s will also
rise proportionately by the cumulative change in CPI
during the bond‟s life. By having an embedded option on
inflation, RRBs can exhibit low correlation with other asset
classes, which should provide diversification benefits.
1
“Renewal of the Inflation-Control Target,” Bank of Canada, November
2011, accessed at <http://www.bankofcanada.ca/wpcontent/uploads/2011/11/background_nov11.pdf>
© 2013 SEI
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inclusion in portfolios that face some degree of risk from
inflation.
The bottom line is that the outlook for inflation is fraught
with uncertainty, and it often is. Monetary and other
policymakers the world over continue to travel in uncharted
waters. Inflation dynamics can and do change, and most
importantly, there is always some risk of inflation
expectations becoming unanchored.
Third, as the IMF article observed, modern developed
economies appear to be more resistant to outright
deflation than they were in the past. Finally, even in a
worst-case scenario—for example, if Canada‟s economy
were to fall into a deflationary malaise similar to the one
Japan has struggled with for two decades (Exhibit 5)—
RRBs would still provide certain benefits, such as
government-guaranteed interest and principal, regular
cash flows, and an additional measure of portfolio
diversification.
Given the damage that inflation does to most financial
assets, investors should at least consider having some
measure of inflation protection. And in SEI‟s view, RRBs
can be an appropriate component in many portfolios.
Our Funds and Strategies
Exhibit 5: Consumer Price Index in Japan
In strategic portfolios where we believe a measure of
inflation protection is warranted, we have incorporated
SEI‟s Real Return Bond Fund. These allocations are
shown in Exhibit 6. SEI remains committed to providing
robust investment solutions. Our aim is to provide mindful
diversification that allows investors to manage the various
risks present in financial markets while pursuing their
investment objectives.
120
Index Level
100
80
60
40
20
0
Source: OECD
Monthly data, June 1955 through May 2013
Exhibit 6: Strategy Allocations to Real Return Bond Fund
ASSET ALLOCATION FUNDS
Income 100
Income 20-80
Income 30-70
Conservative Monthly
Income 40-60
Balanced 50-50
Balanced 60-40
Balanced Monthly Income
Growth 70-30
Growth 80-20
PORTFOLIO MODELS
Short-Term Conservative Income
Conservative Income
Income
Moderate Growth & Income
Global Moderate Growth & Income
Core Growth & Income
Global Core Growth & Income
Growth & Income
Global Growth & Income
Core Growth
Global Core Growth
Growth
Global Growth
Canada-Focused Balanced
Canada-Focused Growth
GOALS-BASED MODELS
Conservative
Moderate
Balanced
Growth
© 2013 SEI
STRATEGIC ALLOCATION TO REAL RETURN BOND FUND
5.0%
7.0%
7.0%
7.0%
8.0%
8.0%
6.0%
6.0%
4.0%
3.0%
STRATEGIC ALLOCATION TO REAL RETURN BOND FUND
5.0%
6.0%
7.0%
8.0%
8.0%
8.0%
8.0%
6.0%
5.0%
4.0%
4.0%
3.0%
3.0%
8.0%
4.0%
STRATEGIC ALLOCATION TO REAL RETURN BOND FUND
3.0%
5.0%
12.0%
6.0%
.
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This material represents an assessment of the market environment at a specific point in time and is not intended to be a
forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as
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There are other holdings which are not discussed that may have additional specific risks. In addition to the normal risks
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from an investment professional.
© 2013 SEI
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