The U.S. and other governments around the world are deploying massive fiscal stimulus to battle the economic effects of COVID-19.1 And as global economies reopen, there is a fear of rising consumer prices.2 These events and others have investors, market strategists, and news media concerned about the potential resurgence in inflation.
The Two Sigma Factor LensTM, the set of risk factors that powers many of Venn's analyses, is designed to help allocators understand the risk drivers of their portfolios and investments. The lens includes a Local Inflation factor, which is intended to help subscribers understand their exposure to the long-term inflation risk premium and short-term inflation surprises within the local currency area.3
Over the next several weeks, we will be posting a series of three blog posts on the topic of inflation:
- Local Inflation Factor Primer: In this blog post, we’ll cover how the factor is constructed, what it means to have exposure to the factor as we’ve built it, and a summary of the factor’s historical performance.
- Factor InVe(nn)stigator: Inflation: In the next blog post, we’ll analyze several inflation-sensitive assets and their exposure to the Local Inflation factor and other factors.
- Managing Inflation Risk in the Current Environment: In the final blog post, we’ll discuss current inflation expectations and how investors can incorporate their inflation views into their portfolio construction and asset allocation decisions.
Local Inflation Factor Construction
In this section, we walk through the general construction process for the Local Inflation factor in the USD version of the Two Sigma Factor LensTM using July 14th, 2020 as an example.
Step 1: Calculating the difference between an inflation-linked bond index and a Treasury index
On July 14th 2020, the Bloomberg Barclays Inflation Linked 7-10 Year Total Return Index returned 0.06% and the Bloomberg Barclays Treasury 7-10 Year Total Return Index returned 0.19%, resulting in -0.13% underperformance of the inflation-linked index over the Treasury index. The idea here is to understand the excess return earned by inflation-linked bonds due to the inflation hedge. Refer to the next section for a detailed discussion on the theory behind the factor’s construction.
Step 2: Residualize the return difference from step 1 to the Core Macro factors
The second step is residualizing the result from Step 1. For this, we need to understand the recent sensitivity of the inflation-linked index underperformance (relative to the Treasury index) to the Core Macro factors: Equity, Interest Rates, Credit, and Commodities. The betas over the most recent 3 years 4 were approximately:
The returns of each of those factors on July 14th were:
Now we need to multiply the betas by the factor returns to determine how much return we should remove from the inflation index underperformance:
The sum of those factor returns is 0.05%. So let’s remove the 0.05% from the -0.13% underperformance to get a residualized Local Inflation return of -0.18%.
Step 3: Volatility scale to 7%
The final step in our process will be to scale the returns of this residualized factor to target an annual volatility of 7%.5 We first need to understand what the recent volatility of this residualized factor has been and then scale the returns up or down to get closer to our volatility target. Over the most recent 3 years 6, the residualized Local Inflation factor has an annualized exponentially-weighted volatility of 5.16%. That means we should scale the return for July 14th by a factor of (7% / 5.16%), or 1.36.
The scalar of 1.36 multiplied by our residualized return of -0.18% from step 2 equals our final, volatility scaled, residualized return for the Local Inflation factor of -0.24% for July 14th.
Theory Behind the Construction of the Local Inflation Factor
Now that we understand the construction of the factor, what does exposure to it mean?
As we saw in the previous section, the Local Inflation factor is essentially positioned long inflation-linked bonds and positioned short nominal bonds. By definition, inflation-linked bonds’ total return = real yield + realized inflation, while nominal bonds’ total return = real yield + expected inflation + inflation risk premium 7. 8
As a result, Venn’s Local Inflation factor is (real yield + realized inflation) - (real yield + expected inflation + inflation risk premium). The real yield terms cancel each other out, leaving realized inflation - expected inflation - inflation risk premium. Therefore, the factor is a blend of long inflation surprises (i.e., realized inflation - expected inflation) and short inflation risk premium. So, if the long-term risk premium is compensated, then the short risk premium component should generate negative returns for the factor. Additionally, positive inflation surprises (i.e., when inflation increases more than expected) benefit this factor.
In summary, Venn’s Local Inflation factor captures the returns to a local-currency inflation hedge that will benefit when inflation surprises to the upside, but otherwise will tend to lose money due to being short the inflation risk premium in nominal bonds.
Historical Performance of the Local Inflation Factor
Exhibit 1 showcases the cumulative returns for the Local Inflation factor since its inception in March 1997. The factor has realized annual returns of -1.4% with a volatility of 7.3% (we are close to our long-term target of 7%, thanks to the volatility scaling step in the factor’s construction). This has resulted in a Sharpe Ratio of -0.2 for this period.
Exhibit 1: Cumulative Returns of the Local Inflation Factor
Source: Venn. Time period: March 3, 1997 - July 21, 2020, using daily data.
The factor exhibited a multi-year run up in the first half of its life, while the factor has been in a fairly steady drawdown since the mid 2000s. Perhaps one reason for this is that investors might have expected higher inflation after massive quantitative easing and other stimulus measures to combat the economic toll of the Global Financial Crisis in 2008. However, high inflation (as measured by percent change in CPI) never really came to fruition, putting negative pressure on the Local Inflation factor. Another possible reason for the 15 year negative performance is that investors might normally require more compensation for holding nominal bonds when they expect higher inflation, leading to an overall positive inflation risk premium, which detracts from the performance of the Local Inflation factor.
Additionally, the factor posted poor returns in two major market crises since the mid 2000s: the Global Financial Crisis (GFC) in 2008 and the recent COVID-19 market crisis, as seen in Exhibits 2 and 3, respectively. Treasury Inflation-Protected Securities (i.e., TIPS) underperformed Treasurys in both crises. Additionally, the ten year breakeven inflation rate declined notably during both periods 9, perhaps partly driven by the collapse in oil prices during both crises.10
Exhibit 2: Cumulative Returns of the Local Inflation Factor During the GFC
Source: Venn. Time period: September 15, 2008 - March 9, 2009, using daily data.
Exhibit 3: Cumulative Returns of the Local Inflation Factor During the COVID Market Crisis
Source: Venn. Time period: February 20, 2020 - March 23, 2020, using daily data.
Now that we have an understanding of the Local Inflation factor, how it’s constructed, the theory behind its construction, and how it has performed historically, we can use it to explain the risk of assets that are commonly viewed by investors as inflation hedges. Stay tuned -- we’ll publish that analysis in the next post in this series on inflation in the next couple of weeks.
*Subscribers will be able to analyze the Local Inflation factor in the USD and GBP versions of the lens only (for more details, read our FAQ). Further, the Local Inflation factors in the USD and GBP versions of the lens are specific to the local market and are therefore distinct from one another.
1 Forbes article “Risk of Stimulus Spending: Are We Headed Toward Inflation - And Pension Devastation?” on May 14, 2020.
2 Financial Times article “US fund managers seek to safeguard portfolios against inflation” on July, 16 2020.
3 The Local Inflation factor is available in the USD and GBP versions of the factor lens only, where there are liquid markets for inflation-linked securities.
4 Specifically, Venn’s residualization involves a rolling multivariate, exponentially-weighted regression using rolling 5-day returns. The lookback period is 3 years, and the half-life is 6 months. Venn uses a shorter time horizon for the rolling residualization window than most institutional investor time frames. Our research indicated that this specification was a long enough lookback period such that the factor relationships weren't overly sensitive or noisy. And it was short enough to capture changes in factor relationships during volatile market environments like 2008 or the recent COVID-19 market crisis.
5 7% is somewhat arbitrary, but we chose it because it sits in between the volatilities of the two foundational factors on Venn, Equity and Interest Rates. 7% is approximately equal to twice the historical volatility of the Interest Rates factor and half of the historical volatility of the Equity factor.
6 Venn calculates recent volatility on a rolling basis using data over the last 3 years. The data is exponentially-weighted, again with a half-life of 6 months. See footnote 4 for more information on the selection of the lookback period length.
7 The inflation risk premium is the compensation that nominal bond investors might require for their exposure to risk of inflation fluctuations.
8 These returns assume that the bonds are held to maturity and are therefore unaffected by mark-to-market moves, such as changes in inflation expectations, changes in real interest rates, transient liquidity effects, etc.
9 Source: Federal Reserve Economic Data.
10 For more on this, read Venn’s eBook Comparing Factor Performance During Three Crises.
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