​PIMCO recently introduced the PIMCO Inflation Strategy, a comprehensive approach to hedging global inflation risks with an additional focus on “playing offense” to take advantage of inflation dynamics. The strategy tactically allocates across a broad opportunity set of real assets, including global inflation-linked bonds, commodities, real estate, currencies and gold. In the following interview, portfolio manager Mihir Worah discusses the strategy’s investment process, the company’s outlook on inflation and how the strategy uniquely applies PIMCO’s real return expertise and risk-factor approach to asset allocation.

Q. What is the PIMCO Inflation Strategy?
Worah: We see this strategy as a comprehensive real return solution for investors seeking to insulate their portfolios from inflation utilising more than simply equities and bonds. We believe investors can substantially improve the inflation hedging characteristics in their portfolios by incorporating a dedicated basket of inflation-related assets.

The PIMCO Inflation Strategy focuses on a number of specific real assets, assets that, in our view, do well when inflation is rising. It consists of global inflation-linked bonds, real estate investment trusts (REITs), commodities, gold and emerging market currencies. Investors frequently tell us they would like to build an inflation-hedging bucket in their portfolio, but don’t know what assets to select and how to alter their allocations over time to enhance the real value of these investments. We developed this strategy in response to this problem.

Additionally, the strategy is designed to enable investors access to PIMCO’s real return expertise – which stems from our real return team dedicated to analysing drivers of inflation and returns in each of these asset classes – as well as our risk factor-based asset allocation approach. Hence, we combine tactical allocation among the inflation-related assets with active management within each component, while seeking to mitigate downside risk during times of extreme market turbulence. Based on this three-pronged approach combining risk factor analysis, relative value and hedging techniques, the PIMCO Inflation Strategy aims to generate a real return that exceeds inflation rates globally.

Q. How does the launch of this new strategy reflect PIMCO’s views on inflation?
Worah: We believe that investors should be prepared for the risk of rising inflation. The macroeconomic conditions that prevailed in the last 20 to 30 years, including persistently low inflation and interest rates along with strong economic growth, are in the midst of a meaningful longer-term shift. The array of policies implemented by developed country governments and central banks to address the global financial crisis has resulted in unsustainably high debt levels and zero-bound nominal interest rates. While these policies have successfully suppressed the risk of deflation and depression risk posed by the crisis, they have also increased the risk of higher inflation in the years ahead. If central banks cannot generate real growth, they will generate nominal growth; and higher inflation is one way to generate the latter in the absence of the former. In emerging markets, we anticipate inflation to be a recurring concern due to stronger growth dynamics and long-term shifts away from saving towards consumption.

Given the above-mentioned risks, we believe investors’ portfolios may be inadequately positioned to positively respond to rising inflation. Over the past 20-30 years portfolios have largely relied on a mix of stocks and bonds, however equities typically deliver the best returns in times of stable inflation and strong growth, whereas bonds generally perform well during periods of flat or falling inflation. In other words, the two asset classes that dominate most investment portfolios don’t perform well in times of rising inflation.

Q. How does this strategy differ from traditional standalone inflation hedging strategies?
Worah: We believe that the Inflation Strategy is a comprehensive approach designed to arm investors with exposure to key inflation-sensitive assets, while letting us use our expertise and resources to decide how much of each asset to purchase in a given environment. The best asset for hedging inflation risks varies depending on the macroeconomic environment. For instance, in stagflationary periods, when inflation is rising and economic growth is low, gold and inflation-linked bonds tend to perform the best. Conversely, in an environment of modest inflation but with significant inflationary risks down the line, similar to the current environment, assets that provide a high level of current income and yield tend to do well. These include REITs and emerging market currencies and bonds. In a situation of sharp or sudden inflation spikes, commodities would be our preferred choice. Therefore, the main difference to our approach is that we will vary our investments over time to capture the best inflation hedging opportunities.

Q. How does PIMCO’s macro investment process inform this strategy?
Worah: PIMCO’s macro investment process includes an outlook on how risk factors tied to certain assets are evolving. These factors include inflation risk, as well as currency, equity and interest rate risks, among others.

Our investment committee generates the broad views on these risk factors, and the asset allocation committee provides guidance on how those views on risk translate into asset allocations. 

I will incorporate these inputs into actively positioning risk factor exposures, along with relative value and quantitative analysis from the real return team that I lead and discussions with the risk management group at PIMCO. With this collective intelligence, I will potentially make adjustments to a baseline allocation that may include inflation-linked bonds, commodities, currencies, gold and REITs. So a lot of resources are brought to bear on the asset allocation.

Q. Could you expand on how the strategy’s multi-asset approach responds positively to inflation and inflation surprises?
Worah: The greatest inflationary threat to traditional portfolios dominated by stocks and bonds is a positive inflation surprise – inflation in excess of what is already priced in and anticipated. There are five critical asset classes that respond positively over different time frames to inflation and inflation surprises. These are inflation-linked bonds, commodities, real estate investment trusts, gold and currencies.

Inflation-linked bonds are most effective at protecting portfolios in a low-growth and high-inflation environment. They are tied directly to inflation as their principal is contractually linked to official inflation rates which capture inflation arising from increases in wages, education costs, medical expenses, and more. The global universe of inflation-linked bonds has grown in recent years, and about 20% of global inflation-linked bonds are issued by emerging market sovereigns.

Commodities such as food and energy comprise about a quarter of the Consumer Price Index (CPI) in developed countries, but are the most volatile CPI components and often are the cause of inflation surprises caused by unanticipated factors such as inclement weather or heightened geopolitical tensions. REITs may provide protection from increases in housing costs and have a high correlation to inflation over longer time periods. Gold has characteristics of both a commodity that is easily stored for a long period of time and a currency whose supply is limited. Finally, we find that inflation hedging of a portfolio can be enhanced by incorporating exposure to a basket of currencies. This can help combat inflation, driven by higher prices of imported goods brought about by weakening currencies. Currencies of emerging countries that are a significant source of imports can provide a higher degree of inflation protection.

By investing in multiple inflation-sensitive asset classes while managing volatility, hedging tail risk and seeking value via active management, the strategy aims to better position investors’ portfolios for inflation.

Q. How do you evaluate and monitor risks in the strategy?
Worah: We appreciate that certain asset classes – whether they are commodities or emerging market currencies – can be volatile and there are times when they could experience large drawdowns. In the PIMCO Inflation Strategy, we focus on building the risk hedging from the bottom up as an integral part of our investment process.

As with our other multi-asset strategies, however, this strategy goes over and above PIMCO’s risk management framework by having a budget allocated to hedging against the possibility of severe downside scenarios. Finding effective, and cost-effective, ways to embed tail risk hedging is one of the goals of the strategy and arguably a strength unique to PIMCO. (Tail risk refers to the possibility of an event occurring on the extreme end of a bell-shaped probability curve.)

Thank you, Mihir.