Inflation, stagflation, interest and stuff

Five Questions for Pimco’s Mihir Worah

By Ben Steverman - Oct 12, 2011 10:12 AM ET  Bloomberg

The next 20 years will have higher inflation and slower growth than the last two decades, and investors need to be prepared, says Mihir Worah, a managing director at Pacific Investment Management Co.
Worah heads the Pimco Inflation Response Multi-Asset Strategy fund. Launched at the end of August, it combines several different ways to protect against inflation. Worah discussed the strategy with Bloomberg.com’s Ben Steverman. Edited excerpts of their conversation follow:

1. How worried should investors be about inflation?
As far as the next six months to a year, not worried. With the 9 percent unemployment rate and the global economy slowing down, there are not going to be a lot of inflationary pressures.

That said, the big picture in our opinion is fundamentally changing. Asia has moved from 20 years of exporting ever-lower prices to the West, to now -- through commodity prices, currencies and wages -- starting to export higher prices to the West. Also in the West, the trend of ever-higher productivity has come to a halt.

So the future has a slightly “stagflationary” smell to it. Not 1970s-style stagflation, with double-digit inflation, but lower growth and higher inflation than the last 20 years. Today’s environment just puts an exclamation mark on it: The U.S. economy is growing at about 1 percent, while inflation is running at 3.5 percent.

2. Why has inflation been so relatively high, and what can investors do about it?

Oil prices have come off the peak somewhat, but in March and April, during the Arab Spring, they went up significantly. Gasoline prices are higher today than when we started the year. The second driver of inflation has been the cost of shelter. As buying housing gets less attractive, there are more and more people renting. Rents are going up. The cost of shelter, or rent, in the U.S. is 30 to 35 percent of the inflation basket. Also, past weakness in the dollar and last year’s increase in cotton prices are feeding into higher clothing prices.

With all the volatility in the markets, everyone is very concerned with capital preservation but no one is focused on inflation. Sneaky, higher-than-expected inflation is another way of eroding your standard of living. It’s something people have to hedge themselves against or prepare themselves for.

Treasury-Inflation Protected Securities, or TIPS, should be the cornerstone of any inflation-hedging program. Their value is guaranteed by the government to go up one-for-one with inflation.

3. The yields on TIPS are pitifully low now, even with inflation creeping higher. What's going on?
Two years ago, 10-year TIPS gave you inflation plus 2 percent. That was very attractive. Today TIPS guarantee that you’ll keep up with inflation but don’t give you any more. You’re not getting any other return on your investment.

I view them as an insurance policy. They’re not your entire portfolio, nor are they going to be return generators. In the last year, TIPS have returned 7 percent. This year, TIPS have returned close to 10 percent. Going forward, I don’t think TIPS are going to give you those kind of returns, but you still need a little bit in your portfolio. If inflation really runs away, TIPS are one of the only things that will protect you.

At Pimco we’ve offered different inflation-hedging solutions. We’ve got a flagship commodity fund. A fund that invests in real estate investment trusts is a good inflation hedge in the U.S. because REITs have to pay out 90 percent of the rents they get in the form of dividends. As every developed-market central bank tries to depreciate their own currency in order to make their economies more competitive, gold starts getting more attractive as a hedge.

So we’ve had all these piecemeal solutions. We decided to come up with a fund that is a one-stop shop. It has a baseline allocation to all these different inflation hedging asset classes: TIPS, commodities, REITs, gold and emerging market currencies. It’s about 40 percent in TIPS and 15 percent each in each of these other asset classes. We will actively manage the mix, based on what we think would be the best hedge for inflation and the best return driver. (The no-load version of the Pimco Inflation Response Multi-Asset Strategy Fund [PDRMX] charges a management fee of 1.1 percent per year.)

4. Some see stocks as a pretty good inflation hedge. What’s your view?
It depends on the time period. Stocks are a good inflation hedge in an economy like we had in the 1990s with strong growth and modest inflation. But if you have hyperinflation, stocks are going to get crushed. So, if like the 1970s -- or like we saw for a couple months this year -- inflation is coming from higher and higher commodity prices, stocks might not be a great inflation hedge.

5. What are the risks of worrying too much about inflation?

Our expectation is a move from a disinflationary epoch to an inflationary epoch. Clearly there are a lot of minefields along the way and what’s happening in Europe is the most important one. You’re worrying about inflation too much if you put all your assets in inflation-hedging programs.

In general, most investors are underinvested in inflation hedges, because we’ve gone through 20 years of low inflation. Strategies such as these are volatile, so you’ve got to make sure that you’ve got the right allocation, whether it’s 5 percent or 10 percent of your broader portfolio.