Fighting Inflation: Going Beyond TIPS

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Includes: BCM, CMD-OLD, CMDT, COMT, CSCB, CSCR, DBC, DDP, DEE, DJCI, DJP, DPU, DYY, FTGC, GCC, GSC, GSG, GSP, IPE, LSC, LTPZ, PDBC, RJI, SBV, SCHP, SIPE, STIP, STPZ, TDTF, TDTT, TIP, TIPX, TIPZ, TPS, UCD, UCI, USCI, VTIP
by: Invesco US

Summary

A strengthening economy and robust employment data have increased the risk of inflation to the US economy.

Historically, commodities have outperformed Treasury Inflation-Protected Securities (TIPS) by a wide margin during periods of notable inflation and rising interest rates.

An investment strategy that combines commodities with floating rate bonds could potentially further mitigate the risks of inflation and rising interest rates.

Commodities Have Proven More Effective In Keeping Pace With Inflation Than Treasury Inflation-Protected Securities

By Thomas Boccellari, Fixed Income Product Strategist

After a surprise jump in US average hourly earnings in November, talk of inflation has begun to heat up. With this in mind, both Goldman Sachs and ETF.com have referenced Treasury Inflation-Protected Securities (OTC:TIPS) as top investment ideas for 2016. TIPS are US government bonds that pay a fixed rate of interest, but have a principal amount that moves up and down with inflation. While TIPS typically offer returns that keep pace with inflation, commodities - including energy and agricultural resources - have historically experienced greater correlation to inflation than TIPS - while also providing higher overall returns.1

Effects of inflation

Inflation can quickly eat away at investors' real (inflation-adjusted) returns. Because of this, many investors look to hedge their inflation risk. Predicting inflation can be challenging, however. The market has typically priced in expected inflation with mixed results. But it's unexpected inflation that can do the most damage to portfolios.

In fact, unexpected inflation has been shown to weigh on both equity and fixed income returns over time. During periods of unexpected inflation, both stocks and bonds have historically generated inflation-adjusted returns of less than 2%. During "normal" periods, where inflation was at or below expectations, real returns have been significantly higher.2

So, how do investors help protect themselves from unexpected inflation? Generally, investors have turned to inflation-linked securities (such as the aforementioned TIPS), or real assets such as commodities. But these offerings have significant differences.

Commodities as a potential inflation hedge

Out of all the major asset classes, commodities and gold have had the highest correlation to the consumer price index (CPI), which is used to calculate inflation in the United States. In fact, from February 1997 through December 2015, commodities experienced a 0.76 correlation to changes in the US CPI. This compares with TIPS' 0.20 historical correlation to changes in the CPI.3

This is not just a US phenomenon. Across nearly every market except Japan, where there has been virtually no inflation for decades, commodities have experienced high correlation to local-market price indexes.4

Commodities may offer global inflation protection across most markets


Commodities may offer global inflation protection across most markets

Source: Bloomberg L.P. from December 1999 through December 2015. U.S. Inflation Index, Global Inflation Index and Commodities Index are represented by the BofA ML US Treasury Inflation-Linked Index, BofA ML Global Inflation-Linked Government Index and DBIQ Optimum Yield Diversified Commodity Index Excess Return, respectively.

Commodities have also delivered strong results during periods of especially high and unexpected inflation. From February 1997 through December 2015, commodities generated average annual returns in excess of 15% when inflation was at or above 2%, while TIPS averaged 5% annually during these same conditions.5

Commodities have historically generated real returns in excess of TIPS during periods of high inflation (>2% Fed Target)


Commodity returns in excess of TIPS during periods of high inflation

Source: Bloomberg L.P. using monthly trailing 12-month returns from February 1997 through December 2015. TIPS are represented by the BofA ML US Treasury Inflation-Linked Index. Commodities are represented by S&P GSCI Index Excess Return from February 1997 through February 2006 and the DBIQ Optimum Yield Diversified Commodity Index Excess Return from March 2006 through December 2015. Average when monthly year-over-year CPI was greater than 2% Federal Reserve target.

Then consider this: When inflation was above 4%, commodities delivered positive returns 100% of the time. TIPS did so 71% of the time.6

TIPS and commodities

Source: Bloomberg L.P. using monthly year-over-year price changes from February 1997 through December 2015 when the CPI was greater than 4%. TIPS are represented by the BofA ML US Treasury Inflation-Linked Index. Commodities are represented by the S&P GSCI Index Excess Return from February 1997 through February 2006 and the DBIQ Optimum Yield Diversified Commodity Index Excess Return from March 2006 through December 2015

Historically, Commodities have outperformed during rising interest rates

But inflation does not occur in a bubble. Unexpectedly high inflation may be the sign of a rapidly growing economy. During these periods, central banks typically take steps to curb inflation by raising interest rates. Historically, TIPS have performed poorly during periods of rising interest rates. This is intuitive because, like traditional government bonds, TIPS have a principal and coupon and are fairly sensitive to changes in interest rates. (In other words, they have high duration risk.) If interest rates rise in between CPI coupon adjustments, the principal will adjust downward. In fact, TIPS' high duration risk may even negate some of their inflation indexation benefits. During periods of unexpected inflation and rising interest rates, TIPS averaged 2.0% in annual returns, while commodities posted average annual returns of nearly 20%.7

In addition, commodities have historically exhibited low correlations to stocks and bonds.8 As investors confront rising rates and equity market volatility, commodities may provide an additional layer of portfolio diversification beyond traditional equity and fixed income allocations. Investors looking for a cost-effective9 and convenient way to invest in commodity futures may wish to consider the PowerShares DB Commodity Index Tracking Fund (NYSEARCA:DBC). DBC tracks the DBIQ Optimum Yield Diversified Commodity Index Excess Return - a rules-based index comprising futures contracts on 14 of the most heavily traded and important physical commodities in the world.

Important information

Sources

  1. Bloomberg L.P., using monthly trailing 12-month returns from February 1997 through October 2015. TIPS and commodities are represented by the BofA ML US Inflation-Linked Treasury Index and DBIQ Optimum Yield Diversified Commodity Index Excess Return, respectively. Past performance is no guarantee of future results. An investment cannot be made into an index.
  2. Bloomberg L.P., using annualized quarterly data between March 31, 1997, and Sept. 30, 2015. Equity and bond returns are represented by the S&P 500 Index and BofA ML U.S. Corporate, Government & Mortgage Index, respectively. Returns are adjusted for inflation. Unexpected inflation is defined as the difference between realized inflation versus the Survey of Professional Forecasters forecast from 12 months prior. Past performance is no guarantee of future results. An investment cannot be made into an index.
  3. Bloomberg L.P., using monthly year-over-year price changes from February 1997 through December 2015.
  4. Bloomberg L.P., February 1997 through December 2015. US inflation and global inflation are represented by the BofA ML US Inflation-Linked Treasury Index and BofA ML Global Diversified Inflation-Linked Government Index, respectively. Commodities are represented by the S&P GSCI Index Excess Return from February 1997 through February 2006 and DBIQ Optimum Yield Diversified Commodity Index Excess Return from March 2006 through December 2015. An investment cannot be made into an index.
  5. Bloomberg L.P. using monthly trailing 12-month returns from February 1997 through December 2015. TIPS and commodities are represented by the BofA ML US Inflation-Linked Treasury Index. Commodities are represented by the S&P GSCI Index Excess Return from February 1997 through February 2006 and the DBIQ Optimum Yield Diversified Commodity Index Excess Return from March 2006 through December 2015. The averages referenced were calculated when the monthly year-over-year CPI was greater than the US Federal Reserve's 2% target. Past performance is no guarantee of future results. An investment cannot be made into an index.
  6. Bloomberg L.P., using monthly year-over-year price changes from February 1997 through December 2015 when the CPI was greater than 4%.
  7. Bloomberg L.P., using monthly year-over-year price changes from February 1997 through December 2015, when realized inflation exceeded the Survey of Professional Forecasters CPI forecast and the 10-year Treasury rate increased more than 100 basis points. TIPS are represented by the BofA ML US Inflation-Linked Treasury Index. Commodities are represented by the S&P GSCI Index Excess Return from February 1997 through February 2006 and the DBIQ Optimum Yield Diversified Commodity Index Excess Return from March 2006 through December 2015. Past performance is no guarantee of future results. An investment cannot be made into an index.
  8. Bloomberg L.P., Dec. 31, 2015.
  9. Since ordinary brokerage commissions apply for each buy and sell transaction, frequent trading activity may increase the cost of ETFs.

Correlation is the degree to which two investments have historically moved in relation to each other. A correlation of 1.00 means that the investments have moved perfectly in tandem.

Duration, which measures the price sensitivity of a fixed income investment to interest rate changes, is the number of years it will take a bond's cash flow to repay an investor the bond's purchase price.

Inflation is the rate at which the general price level for goods and services is increasing.

The consumer price index measures change in consumer prices as determined by the US Bureau of Labor Statistics.

Treasury Inflation-Protected Securities are US Treasury securities that are indexed to inflation.

The real value of assets is the value of assets adjusted for inflation.

DBIQ Optimum Yield Diversified Commodity Index Excess Return is based on 14 commodities drawn from the energy, precious metals, industrial metals and agriculture sectors.

The BofA Merrill Lynch US Inflation-Linked Treasury Index is an unmanaged index comprised of US Treasury Inflation-Protected Securities with at least $1 billion in outstanding face value and a remaining term to final maturity of greater than one year.

The BofA Merrill Lynch Global Diversified Inflation-Linked Index is a broad, market-value weighted, capped total-return index designed to measure the performance of inflation-linked sovereign debt that is publicly issued and denominated in the issuer's own domestic market and currency.

Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest.

Investments focused in a particular industry or sector are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.

Debt securities are affected by changing interest rates and changes in their effective maturities and credit quality.

There is a risk that the Federal Reserve Board (NYSE:FRB) and central banks may raise the federal funds and equivalent foreign rates. This risk is heightened due to the potential "tapering" of the FRB's quantitative easing program and other similar foreign central bank actions, which may expose fixed income investments to heightened volatility and reduced liquidity, particularly those with longer maturities. As a result, the value of the Fund's investments and share price may decline. Changes in central bank policies could also increase shareholder redemptions, which may increase portfolio turnover and fund transaction costs.

The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

IMPORTANT CONSIDERATIONS:

Commodity and futures generally are volatile and are not suitable for all investors.

The PowerShares DB Commodity Index Tracking Fund is not suitable for all investors due to the speculative nature of an investment based upon the Fund's trading which takes place in volatile markets. Because an investment in futures contracts is volatile, such frequency in the movement in market prices of the underlying futures contract could cause large losses.

The value of the Shares of the Fund relate directly to the value of the futures contracts and other assets held by the Fund and any fluctuation in the value of these assets could adversely affect an investment in the Fund's Shares.

Please review the prospectus for breakeven figures for the Fund.

The Fund is speculative and involves a high degree of risk. An investor may lost all or substantially all of an investment in the Fund.

The Fund is not a mutual fund or any other type of Investment Company within the meaning of the Investment Company Act of 1940, as amended, and is not subject to regulation thereunder.

This material must be accompanied or preceded by a prospectus. Please read the prospectus carefully before investing.

Shares are not individually redeemable and owners of the Shares may acquire those Shares from the Fund and tender those Shares for redemption to the Fund in Creation Unit aggregations only, typically consisting of 200,000 Shares.

The Shares are not deposits, interests in or obligations of any Deutsche Bank, AG, Deutsche Bank, AG London, Deutsche Bank Securities, Inc. or any of their respective subsidiaries or affiliates or any other bank (collectively, the "DB Parties") and are not guaranteed by the DB Parties.

"Deutsche Bank," "DBIQ Optimum Yield Diversified Commodity Index Excess Return™" is reprinted with permission. © Copyright 2016 Deutsche Bank AG. All rights reserved. "Deutsche Bank," "DBIQ Optimum Yield Diversified Commodity Index Excess Return™" is a service mark of Deutsche Bank AG and have been licensed for use for certain purposes by Invesco Distributors, Inc. The Fund is not sponsored or endorsed by Deutsche Bank AG. Deutsche Bank AG, as Index Provider, makes no representation, express or implied, regarding the advisability of investing in this product. As the Index Provider, Deutsche Bank AG is licensing certain trademarks, the underlying Index and trade names which are composed by Deutsche Bank AG without regard to Index, this product or any investor.

ALPS Distributors, Inc. is the distributor of PowerShares DB Funds. Invesco PowerShares and Invesco Distributors, Inc. are not affiliated with ALPS Distributors, Inc.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE

All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.'s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.

©2016 Invesco Ltd. All rights reserved.

Fighting inflation: Going beyond TIPS by Invesco Blog

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