By David Schassler
Portfolio Manager and Head of Quantitative Investment Solutions
Van Eck Associates Corporation
A diversified mix of inflation-fighting assets are key to successfully navigating the current inflationary environment.
The U.S Federal Reserve (Fed), and the market overall, may be gradually coming to terms with the inflation problem. Only one short year ago, the Fed wasn’t “thinking about thinking about raising rates.” In March 2021, the Fed indicated that rate hikes were not expected until at least 2024. It is now April 2022, just a year later, and the Fed has already hiked rates by 0.25% and now anticipates six more rate increases in 2022. This is in addition to anticipation of the Fed rapidly shrinking its balance sheet. While the U-turn was drastic, this pivot is totally appropriate given the inflationary pressures.
We believe the chances that the Fed will be successful in pulling this off without wreaking havoc on the economy are extremely low. The chart below demonstrates the Fed’s track record for fighting inflation. In all events since 1970, raising interest rates to combat inflation resulted in rising unemployment. We are now contending with the worst bout of inflation since the 1970s. During that period, the tightening process to combat inflation resulted in an unemployment rate of 10.7%. That level exceeded the unemployment rate during the Global Financial Crisis of 2008!
Rates vs. Unemployment
Data as of April 7, 2022. Source: Bloomberg. Past performance is not a guarantee of future results.
The chart below demonstrates that the yield curve recently inverted. This is signaling that the market anticipates that the Fed will pause on tightening next year. Embedded within that is the assumption that the Fed will be successful in taming inflation while maintaining negative real interest rates—which, by the way, has no historical precedent. Stagflation is the more likely outcome.
Yield Curve Inverts
Data as of April 7, 2022. Source: Bloomberg and The National Bureau of Economic Research. Past performance is not a guarantee of future results.
Russia’s invasion of Ukraine only makes a bad situation worse. The chart below demonstrates that, historically, wars have coincided with higher inflation. Russia is a top three global supplier of energy, base metals, precious metals, bulk metals, fertilizers and soft commodities. Its significance as a commodity producer, combined with pre-existing supply and demand imbalances in the commodity markets, make this conflict particularly inflationary.
CPI Year over Year
Data as of February 1, 2022. Source: Bloomberg. Past performance is not a guarantee of future results.
The Fed is in a precarious situation and history is not on its side. Investors should strap in because the ride is likely to get much bumpier. Now is the time for diversified inflation protection.
We believe that the key to successfully navigating this environment is to own a diversified mix of inflation-fighting assets and to own enough of them to protect your portfolio if, as we expect, this high inflation regime continues. Based on previous inflation cycles, we estimate that allocation should be approximately 15% of your total portfolio.
We manage the VanEck Inflation Allocation ETF (RAAX), which offers diversified exposure to key inflation-fighting assets. RAAX has been gradually increasing its exposure to both gold and gold equities, and its total exposure to gold is now nearly 20%. We have been vocal advocates for gold as a significant component of an “anti-inflation” allocation. We continue to point out that, for gold to materially outperform, the market needs to fully contextualize the severity of the inflation problem. Unfortunately, we believe that the market still underappreciates the risks of inflation, but that may be slowly changing. Year-to-date, relative to the S&P 500® Index, gold bullion is now outperforming by more than 10% and gold equities are outperforming by nearly 25%. We expect this segment of the portfolio to lead RAAX’s performance higher as the inflation cycle continues to mature.
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CPI – US CPI Urban Consumers YoY NSA Index measures US consumer prices (CPI) as a measure of prices paid by consumers for a market basket of consumer goods and services. The yearly (or monthly) growth rates represent the inflation rate.
Commodities – Bloomberg Commodity Index is made up of 23 exchange-traded futures on physical commodities, representing 21 commodities, which are weighted to account for economic significance and market liquidity.
Gold – Gold spot price in U.S. dollars per troy ounce.
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