Non-profits: Should inflation risk management be your goal?

Executive summary:

• Although it is more difficult to achieve CPI + targets when inflation is elevated, periods of rising inflation¹ are the most problematic.
• Adjusting a portfolio to reduce exposure to unexpected inflation can cause the portfolio to be more exposed to other macroeconomic shocks, such as declining growth.
• Unless inflation poses a specific risk to your organization, we believe the best route forward is likely a diversified portfolio that is as robust as possible across different economic environments.

Over the past two years, higher inflation has led to a higher return hurdle for investors who have established real return objectives, making it harder for them to achieve their return objectives over the short term. But is this likely to be the case over the long term as well?

Let's take a look by addressing the following three key questions:

1. Impact of inflation on the likelihood of achieving goals

Given that most non-profits are aiming to maintain purchasing power through time, their stated objective is typically to achieve returns in line with inflation (as measured by the consumer price index, or CPI) to preserve the real value of the corpus, plus an additional return premium to support ongoing spending. A period of higher-than-average inflation naturally makes this goal more challenging, but perhaps somewhat surprisingly, not unreasonably so.

To understand why, take a look at Exhibit 1 below, which illustrates the impact of higher-than-average inflation on the ability to meet nominal and real return objectives from 1950-2022 for a simple portfolio of 80% global equity and 20% U.S. aggregate bonds.

Over this 72-year period, the average annual inflation rate was 3.56%, so a CPI + 5% objective should be roughly equivalent to a nominal return objective of 8.5%. Exhibit 1 illustrates the ability to achieve the objectives over all periods (for which average inflation was 3.5%) and secondarily assesses the ability to accomplish the objectives over the sub-set of periods for which inflation was over 3.5%. As the chart shows, the ability to reach the nominal return targets is relatively unchanged by the level of inflation. In other words, achieving the inflation-plus objectives are made more challenging by intervening periods of high inflation, but the overall likelihood of meeting goals is not unreasonably reduced.

Exhibit 1: Likelihood of meeting return objectives with an 80/20 portfolio in all periods, and the sub-set of periods in which inflation is over 3.5% from 1950-2022

Next up, Exhibit 2 shows the probability of meeting the portfolio goal in periods for which the annualized inflation is over 1% higher than the preceding non-overlapping period. Critically, the results indicate that rising inflation is particularly harmful to portfolios, not necessarily the absolute level of inflation itself. As shown, the time periods where inflation is rising by over 1% have less than a 50% probability of meeting the return objective.

Exhibit 2: Likelihood of meeting return objectives with an 80/20 portfolio in all periods, and the sub-set of periods in which inflation is rising by over 1% from 1950-2022

2. Considering portfolio success risk factors beyond inflation

Before constructing a portfolio focused on protection from unexpected inflation shocks,² it is important to remember that inflation shocks are not the only macro factor that can make it difficult to reach objectives. Shocks to aggregate economic growth can also significantly impact portfolio outcomes. An example of a growth shock is a recession, with negative real growth over two consecutive quarters, but you can also have a growth shock without a recession.

Exhibit 3 looks at the impact of a negative real growth shock (e.g., recession) by comparing periods in which total annualized real growth is decelerating by 1% or more relative to the entire period. The key takeaway is that negative growth shocks impair the portfolio's ability to meet inflation-relative and nominal return objectives.

Exhibit 3: Likelihood of meeting return objectives with an 80/20 portfolio in all periods, and the sub-set of periods in which real growth is decelerating by more than 1% from 1950-2022

This underscores our point that rather than solely worrying about high inflation, non-profit investors should be concerned about the multiple macro risk dimensions that could negatively impact the likelihood of reaching their objective.

3. Portfolio positioning considerations

To construct a portfolio that will best meet its objectives, it is important to look at its sensitivity to risks relative to the objective from a multi-dimensional risk lens.

The CPI + objective has a beta of 1 to unexpected inflation, which means when the realized inflation is higher than expected by 1%, the investment goal itself rises by 1%.

If the investor's portfolio also has an anticipated beta of 1 to unexpected inflation, it is expected to move in line with the investment objective in periods of rising inflation. For other macro risks like growth shocks, the ideal portfolio has a beta of zero to them if that could be done without impacting the return expectation. If we hold a portfolio with a beta of 1 to inflation shocks and zero to other risk factors, then we could theoretically insulate the portfolio from shocks relative to the investment objective.

Of course, even if the sensitivity of the asset classes to macro shocks could be determined without any uncertainty, this could be difficult to accomplish. It is possible that tilting into certain asset classes helps reduce the macro risk of the portfolio on one dimension while increasing it on another. For example, tilting into real assets and out of duration are likely to increase the beta to both inflationary shocks (good) and growth shocks (bad). This would require a trade-off to be made. However, caution must be taken in relying upon asset classes with expected inflation shock protection as the beta estimates can be regime dependent. For a deeper dive into this, please check out the complete version of our research paper.

Ultimately, in determining the extent to which a non-profit entity should be concerned about the impact of inflationary, growth, or other market shocks on portfolio growth and spending, the circumstances of the non-profit need to be thoroughly considered.

For all spending non-profits, inflation will erode the beneficial impact of your spending (in tangible terms). However, declining growth will also impact the portfolio and likely concurrently reduce the donations received (at just a time when increased support is needed).

In short, weighing the probability of each risk within your strategic asset allocation is crucial, recognizing that protecting against shocks in unexpected inflation may prove to be less critical versus others, such as declining economic growth.

The bottom line

Although a persistently high level of inflation might be problematic for an organization's investment objectives, it is inflation being unexpectedly high that is the more significant concern. However, there are other risks that can knock you off your path to your CPI + objective. Unless inflation poses a specific risk to your organization, we believe the best route forward is likely a diversified portfolio that is as robust as possible across different economic environments.

¹ We define rising inflation as an environment where the current realized inflation over a horizon (3Y, 5Y, or 10Y) is higher than the inflation over a recent similar non-overlapping period in history. For example, if the realized 5Y inflation from 2015-2020 is higher than the 5Y inflation from 2010-2015, we will classify 2015-2020 as a period of rising inflation over a 5Y horizon. It should be noted that for the ten-year horizon, all data points for rising inflation occur for ten-year horizons period ending between 1970 and 1985, and for the five-year horizon all but two are from 1968-1982, which should lead to caution in drawing robust conclusion from one period in history.

² Attié, A. P., & Roache, S. K. (2009). Inflation hedging for long-term investors. International Monetary Fund, Finance Department. Available at: https://www.imf.org/external/pubs/ft/wp/2009/wp0990.pdf