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A Framework for Thinking About Rising Inflation: Think Function, Not Form

February 2018
By Nanette Abuhoff Jacobson, Managing Director and Multi-Asset Strategist at Wellington Management LLP and Global Investment Strategist for Hartford Funds

Consider using "Think Function, Not Form" to help ensure that your portfolio contains assets that have the potential to generate positive returns in multiple economic environments.

Think Function, Not Form (TFNF) is an asset allocation framework I use to help me construct portfolios with diversified exposure to investments that have the potential to generate positive returns in A variety of economic environments. This intuitive framework categorizes several major asset classes according to how they have historically performed during four economic regimes: growth, inflation, stagflation,1 and weak growth.


Figure 1

Four economic regimes in Think Function, Not Form



Source: Wellington Management; Note: | Economic environments are defined by year-over-year changes in gross domestic product (GDP)2 growth and inflation. Growth: + GDP growth, – inflation; Weak growth: – GDP growth, – inflation. Inflation: + GDP growth, + inflation. Stagflation: – GDP growth, + inflation


I have found that most clients’ portfolios are dominated by assets that tend to do well during periods of rising growth and falling inflation, such as equities and assets with equity-like characteristics, including high-yield bonds (the top-left quadrant of FIGURE 2). On the other hand, clients tend to lack exposure to assets that historically have tended to fare well during periods when inflation is rising, regardless of whether growth is rising or falling. These include emerging market currencies, natural-resources equities, industrial metals, Treasury inflation-protected securities (TIPS),3 and precious metals (the bottom-right quadrant of FIGURE 2).


Figure 2

Asset classes that have historically outperformed in each economic environment



Source: Wellington Management
Note: The example presented is for illustrative purposes and reflects the current opinions of Wellington Management global Multi-Asset Strategies team as of the date appearing in this material only. This is based on historical assumptions and is not intended to be a prediction of how any asset class will perform in the future. 


This may be because inflation and weak growth occur relatively infrequently. But investors should consider being prepared regardless, as portfolios that are underweight assets that perform well during these regimes can face significant losses. The TFNF framework can help investors see the merits of building diversified portfolios with appropriate weightings across environments. In this paper, I focus on the right-hand side of TFNF: assets that tend to outperform during periods of inflation or stagflation. Today, I foresee a period of rising inflation for which I think most portfolios are ill-prepared. 



Commodities6 as a whole tend to perform well when inflation rises; however, their correlation with economic growth varies by individual commodity and by whether supply or demand is driving prices higher. Industrial metals (zinc, nickel, platinum, aluminum, and copper) are the most sensitive to inflation and also typically rise in price in response to improving growth. Natural-resource equities have similar characteristics but are somewhat less sensitive to inflation. Energy’s sensitivity to growth varies, which is why it straddles the rising- and falling-growth quadrants. Sometimes rising energy prices coincide with rising growth and demand, but they can also be stagflationary if the price increases are driven by a supply shock, leading to weaker growth.

Agriculture commodities (coffee, wheat, soybeans, sugar, cotton, corn, and livestock) are generally inflation sensitive but neutral to growth, because supply-and-demand drivers are generally independent of economic growth. Things such as weather affect supply (and therefore prices), while demand is relatively inelastic: People are going to eat whether the economy is growing or not.

Gold and precious metals tend to do well in periods of stagflation, as investors use these assets as currencies in times of financial stress.


Fixed income

TIPS benefit from higher inflation and weaker growth, making them one of the few assets other than gold that historically performed well during stagflation. TIPS have three return components: real yield,7 duration8 (changes in the real yield), and an inflation-adjusted principal, which moves with the consumer price index (CPI).9 A key to understanding TIPS is that returns from changes in the real yield often outweigh the inflation adjustment, especially for long-dated securities. For this reason, investors may want to consider shorter-duration TIPS, which can compensate investors for inflation without the sensitivity to changes in real yield.

Bank loans straddle the growth and inflation quadrants, meaning they tend to do well during periods of growth and are neutral to inflation. This is because bank loans’ cash flows are based on a floating-rate index plus a credit spread. The floating-rate component generally delivers returns in line with the benchmark, typically the 3-month London Interbank Offered Rate (LIBOR).10 Growth-induced inflation is likely to be reflected in higher Federal Reserve (Fed) funds rate expectations and, as a result, other short-term rates will tend to rise as well. Bank loans’ spread component is essentially compensation for credit risk and is strongly related to growth; if growth improves, that spread narrows, likely delivering positive returns.


Emerging markets debt

Emerging markets debt (EMD) varies in its sensitivity to inflation. US-dollar-denominated EMD generally benefits from higher inflation, which often corresponds with declining value of the US dollar. A weaker dollar lowers debt burdens in local currency terms, reducing the risk of default. Emerging markets local debt (ELD) tends to offer more inflation sensitivity because many large debt issuers are commodity producers whose interest rates and currencies tend to be supported by rising commodity prices. For example, local debt issued in Russia and Brazil—two economies heavily reliant on commodity exports—would theoretically respond well to rising inflation, because rising commodity prices could improve those countries’ terms of trade.



Many investors assume that equities are a hedge against inflation, but that turns out to be something of a fallacy for most sectors. Energy equities naturally have the greatest correlation with inflation because higher underlying commodity prices are revenue drivers for commodity-producing companies. Most other types of equities generally excel during periods of growth, but only when inflation is steady or falling. This may be because low or stable inflation tends to correspond with greater economic stability and therefore a lower risk premium, which pushes up equity valuations. Additionally, businesses may have trouble passing along inflation to consumers, so rising inflation can squeeze margins.

While TFNF is based on the changes in growth and inflation, our research indicates that the starting level of inflation matters. When the inflation rate is below 3%, equities tend to perform well when the rate rises but poorly when it falls, as deflation concerns surface. However, when inflation is above 3%, equities tend to do poorly when that rate rises because of concerns about companies’ inability to pass along these price increases to consumers.

Cyclical sectors, including consumer discretionary, industrials, and materials are typically the most sensitive to growth and inflation, while defensive sectors such as health care, telecommunications, consumer staples, and utilities are the least growth sensitive, typically underperforming during periods of higher inflation (FIGURE 3).


Figure 3

Equity sector sensitivities to global growth and inflation vary


Note: This graph plots the betas11 of quarterly asset returns to the quarterly change in year-over-year inflation and real GDP growth from a multi-factor regression.
The indexes used for the asset classes are all Datastream sector indexes. Sources: Wellington Management, Datastream; As of 12/31/16. Most recent data available.



Finally, our research has found that REITs also straddle growth and inflation. Rising real estate prices are generally driven by a strong (growing) economy. However, REITS exhibit varying degrees of interest-rate sensitivity, depending on the lease terms of the underlying assets. Longer-term leases, such as those for offices, healthcare, and retail, are generally less sensitive to an uptick in inflation because investors need to wait for new leases to reset to current market pricing. REIT sectors with shorter-term leases, such as apartments, lodging, and storage facilities, typically reset more quickly and can pass along rising prices.

Investment Implications

Consider using Think Function, Not Form to help ensure that your portfolio contains assets that have the potential to generate positive returns in multiple economic environments.

Consider adding inflation-sensitive assets. Accelerating growth in many places around the world, higher wages, increased fiscal easing, and declining supplies of oil and other commodities suggest that inflation may be headed higher. While commodity prices rebounded over the past year, valuations remain depressed in light of low inflation expectations that have prevailed over the past five years.

Consider commodities and commodity-related equities. The economic cycle is in the later stages, a period when commodities tend to perform well. I particularly like industrial metals, where supply is being restrained after a period of significant excess capacity and new anti-pollution measures.

Consider inflation-linked bonds (ILBs). Inflation is my base case, but stagflation is a risk. These are one of the few assets that tend to perform well in stagflation. Investors may choose to increase exposure to ILBs, but with real yields so low today, they may prefer exposure through break-even inflation rates, which are pricing in low inflation for years to come. Gold and other precious metals can be also well-suited for stagflation but are vulnerable to rising real yields.

Consider scaling into emerging markets debt and currencies. USD-denominated EMD and ELD are attractively priced relative to corporate and high yield bonds and could benefit from stronger global growth and higher commodity prices. But a significantly stronger US dollar and higher yields could be a headwind.

Nanette Abuhoff Jacobson
Managing Director and Multi-Asset Strategist at Wellington Management Company LLP and Global Investment Strategist for Hartford Funds.

1 Stagflation is a condition in which growth is falling but inflation is rising.

2 Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.

3 Treasury inflation-protected securities (TIPS) are Treasury bonds that are adjusted to help eliminate the effects of inflation on interest and principal payments, as measured by the Consumer Price Index (CPI).

4 REIT, which stands for Real Estate Investment Trust, is a company that owns or manages income-producing real estate. REITs are dependent upon the financial condition of the underlying real estate. Risks associated with REITs include credit risk, liquidity risk, and interest-rate risk.

5 Emerging Market Debt (EMD)

6 A commodity is food, metal, or another fixed physical substance that investors buy or sell, usually via futures contracts.

7 Real yield is a yield that has been adjusted to reflect the effects of inflation.

8  Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.

9 Consumer price index (CPI) in the United States is defined by the Bureau of Labor Statistics as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”

10 LIBOR (London Interbank Offered Rate) is the world’s most widely used benchmark for short-term interest; it is the interest rate at which banks bank borrow funds from other banks in the London interbank market.

11 Beta is a measure of risk that indicates the price sensitivity of a security or a portfolio relative to a specified market index.

The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

All investments are subject to risk, including the possible loss of principal. Foreign investments can be riskier and more volatile than U.S. investments due to the adverse eff ects of currency exchange rates, differences in market structure and liquidity, as well as political and economic developments in foreign countries and regions (e.g. “Brexit”). These risks are generally greater for investments in emerging markets. Fixed Income risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall; these risks are currently heightened due to the historically low interest rate environment. Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Municipal securities may be adversely impacted by state/local, political, economic, or market conditions. Investors may be subject to the federal Alternative Minimum Tax as well as state and local income taxes. Capital gains, if any, are taxable. Commodities may be more volatile than investments in traditional securities. Bank loans can be difficult to value and highly illiquid; they are subject to credit risk, bankruptcy risk, and insolvency. Risks of focusing investments on the healthcare related sector include regulatory and legal developments, patent considerations, intense competitive pressures, rapid technological changes, potential product obsolescence, and liquidity risk. The value of inflation-protected securities generally fluctuates with changes in real interest rates, and the market for these securities may be less developed or liquid, and more volatile, than other securities markets. The main risk of real estate related securities is that the value of the underlying real estate may decrease in value.

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