Prepping Portfolios for Inflation

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Hello and welcome to The Way Forward. I'm Jack Otter, and today we have a special guest to discuss a topic that's on a lot of minds, especially as the Biden administration rolls out a massive infrastructure plan. I'm going to speak with the Chief Investment Officer at Region Atlantic, Chris Cordero, who is bracing his client portfolios for the possibility of inflation, a word we haven't heard for decades. Chris, thanks a lot for joining us.

Thanks for having me.

You obviously are, are very much an investor. You have been for decades, and I think you take a more active role actually in your firm's investment choices than a lot of chiefs do. But you said it's also something that's coming up with clients. However, not all clients. Can you explain who's worried about inflation and who's not?

Yeah, Jack, that's the interesting thing. Clients that are over age 60 are concerned about inflation. Clients below age 60 really have no idea of what inflation is. And let me start with the below age 60 and give them a pass of why they're feeling that way. It's because for the last 10 or 20 years, we've experienced extremely mild inflation. And on a lot of things we have, especially technology goods, things have gotten better, faster, and cheaper at the same time. So the notion of things that you want to buy costing you more money is really foreign to younger investors. But for folks who are over age 60, they're old enough to remember and have been economically sort of alive during the '70s and early '80s when we had rampant inflation and you had this real difficulty of people running out of money who were living on a fixed income. That was a huge scare. And so, you know, they're old enough to remember the scary monster stories of inflation, whereas younger investors really don't quite get how bad it can be.

That's really interesting. I don't know if that counts as recency bias or what, but—

Yeah, long-term recency bias.

Yeah, but it really is. I'm old enough to remember as a kid, my parents rolling over CDs. They were very excited about the rates that they were getting. I guess they were in the teens, which is kind of hard to imagine. So that's what your clients are worried about. It has to do with their own life experiences. You try to look at the future with a neutral investment manager's attitude. What do you see out there from a macro perspective?

Well, here's what I think. Is it— so the— you're just going back to the '70s and '80s for a quick stop there. Is it largely that was driven by stagflation and rising wages. And that was the big problem there is that it was a spiraling upward of inflation. And I don't think we're going to see that now.

But just to quickly, I think most of our listeners understand, but stagflation is where you've got low growth but prices going up. Is that right?

Exactly. And that's sort of a double whammy. And that's what was going on in the '70s that made it so particularly painful. And it was a persistent problem. And so what we have to look at now on the macro sense is we have a huge amount of stimulus being pumped into the economy. At the same time, we have a lot of pent-up demand because we've all been shut away for the past year. So that has the capacity of really spiking inflation. So I think it's a very high probability that we'll definitely see a spike in inflation over the next couple of years. So things will start costing us more and we'll notice it. The real question is, does that spike end up spiraling upward into wage inflation? And if we get wage inflation, then that becomes a more difficult problem because it spirals. Wages go up and then therefore people have more money to spend on goods and services. The price of those goods and services go up and you start spiraling out of control. I don't think that's going to happen, but that's the risk.

Yeah. So I've always heard that it is wage inflation that really can move the needle. What are the forces that push that higher? Is that simply like everything else, supply and demand? If the supply of workers is not high enough, then businesses start to have to pay more?

Exactly. It's supply and demand. And the reason why I don't think it will become a problem is because the labor force has become globalized. And so if labor is more expensive in the US, well, we can find it cheaper in other countries and we can have the labor done elsewhere. Certainly even in the professional jobs, look at how Zoom has changed our world. So the ability to get a professional elsewhere in the world to do things for less when they don't have to be physically present, I think we'll keep a lid on the wage inflation issue.

Yeah, so that's a really important point. All the forces that were tamping down inflation for many years are really still there at the macro level. You know, it's funny, Larry Summers, who recently raised an alarm about the stimulus causing inflation, you go just a few months earlier and Summers wrote a great primer on why he doesn't expect to see inflation. And one of those reasons was the one you just explained. There's also demographics. An aging society. The presumption is that as people age, they spend a little less. They're not buying new houses and sending their kids to college and everything else. And also, they're a little bit less productive. And importantly, growth is slowing. I mean, I'm not sure what the population growth is in the US, but I think it's less than 2% now. And if you took out immigration, it would be very close to zero. So all of those, plus the globe, you know, the ability to not only find labor overseas, but also to buy that, that cheap computer, um, from Taiwan. Those are all dampening inflation.

Yes. Yeah, it's interesting. Interestingly, the pandemic did not give us the population boost we thought it might have. It actually went, you know, it actually went in the other direction.

Well, if you had one kid in your house, you're like, I do not want another until we can get outside and I can send them to school again.

Exactly. There was no way to get a second if you only have one.

So does that mean that you would see the possibility of a relatively short-term spike as a result of the forces you outlined, but then going back on the longer-term trend that we have seen. And to me, it seems like the market is kind of supporting that thesis. I believe that 10-year TIPS are not reflecting much inflation, whereas 5-year TIPS are showing, yeah, maybe there'll be a little inflation.

Well, they're, I mean, they're actually both projecting about 2.5% of implied inflation. Which isn't terrible. And to go, but just to go back to, so what should you be preparing clients for? What I believe is that we're most likely to see a spike in inflation. I think that's priced in there and that's a pretty high probability, but there is the risk of a spiraling inflation if we get this wrong. And so for Clients, what I think we need to do, and our clients at Region Atlantic are almost all individuals. We do have some foundations, but the vast majority of people we're investing money for is individuals. And individuals' largest financial goal is to be able to sustain their lifestyle throughout their retirement. And so if we think about portfolios in that perspective, I really need to be mindful of the fact that at the underlying ability to achieve that goal is not outperforming some benchmark index. The underlying ability to achieve that goal is to generate a cash flow stream that can be inflation adjusted upward. And so with that in mind, it's a, you really want to look at the possibility of spiraling inflation and have some things in your portfolio that are going to help you out in the eventuality that that does occur.

So purchasing power is really the key there. As you talked about your clients, I realized that I was so excited to jump right into the inflation topic. We never gave listeners a view of your business. So real quick, can you just, what's your AUM? How many clients do you have?

Sure. So Region Atlantic's AUM is a little over $5 billion. That is for about 1,200 or so client families. And so the, and our clients are, are reasonably well off, but their primary concern and their financial goal is providing for their retirement.

How many people work in your shop roughly?

Roughly 70.

That's a pretty big RIA. Let's talk about the portfolio, kind of the allocation and structure, and then we'll take a deep dive into particular assets that you find attractive if you're worried about inflation. So how are you thinking about structuring those retirement portfolios to make sure you maintain purchasing power?

So what I think you need to do is you need to use the same type of asset allocation and mean-variance optimization that all portfolios are built on. But when I think when there's a tie for something, the tie's got to go to the asset class that's going to give you some inflation protection. And so when they say in baseball, tie goes to the runner, The tie-in portfolio management would be the asset class that would give you a little bit more inflation protection. So a really good example of that are TIPS. So I believe that if you're managing a client's portfolio for inflation and you're going to own treasuries, I think TIPS should be a really important component of that fixed income allocation. And the reason is because when it's a tie and we get inflation expectations that the market assumes are already priced in, you get about the same return as treasuries. But when inflation comes in over expectations or just the expectation that inflation's going to be higher than it was assumed, you're going to have a natural hedge against that in the portfolio. And so I think you need to be mindful of that as you're managing portfolios for individuals.

So to say, talk about 10-year TIPS for now, just because that's the 10-year treasury is the benchmark that everyone is using. What kind of a return are you seeing in it? There's the adjustment plus the actual yield. You can explain that a little bit.

And let's use that to sort of build up how do you get to the inflation assumption in TIPS. And Jack, I'm going to use round numbers so that we don't have to do some heavy duty math here.

Please.

Okay. So let's say that the 10-year Treasury is yielding about 1.75%, right? Um, and at the same time, the 10-year TIP has a negative current yield of 75 basis points. So when you add the two of them together, you get an inflation expectation of 2.5%. In other words, the, the 10-year TIP, it has a negative 0.75% yield on it. Because the coupon payment every 6 months is indexed upward by the change in CPI and the final maturity value is indexed upward by the change in CPI. If, as long as inflation comes in at 2.5%, you'd get the same 1.75% you would've got if you held a 10-year Treasury to maturity. And so that's how you develop that sort of implied inflation rate in TIPS.

So, uh, let's say I'm a client of yours who does not know who Fonzie is, and I'm looking at my portfolio and I'm saying, Chris, you're— explain this to me. You are giving me something with a negative yield. Now, you just did the math for me, sure, uh, 1.75 minus 2.5, um, but do you find yourself having to explain more deeply why something that these people have never experienced is something you, their advisor, their fiduciary, is going to try to protect them against? Yeah.

Not too often because the TIP, I mean, the TIP, if we buy a 10-year TIP, it's priced at a premium. And so most clients, the bond math gets beyond them. And so they never actually experience this negative, actual yield that you're getting because you're losing the premium. But so thankfully that's not too much of an issue.

Let me ask you one other question about TIPS, which is with many investments, the ideal scenario is to be the buyer of the security before the rest of the world realizes that this is something of value, right? You know, you want to buy what's hated and then it becomes loved. With TIPS, it's a little bit different, right? You could wait until you can see the whites of inflation's eyes to get in. Am I right about that?

Uh, no.

Okay, good. So, you know, I seriously, I just want you to know, I have been asking this question since, um, the early 2000s when I was an editor at Smart Money magazine, which does not exist anymore. And I've always got a waffle, and you are now going to give me a definitive answer, and I'm very excited about this.

And the reason is because TIPS, the price of TIPS don't move on the current inflation. The price of TIPS move on inflation. And so if you're not going to buy it until expected inflation is already a threat, well then you've already missed the price movement and you're missing the hedge.

Gotcha. So that is helpful. So now the question Do you buy individual tips? Presumably you're not going to buy funds in that case.

You can buy funds, but right now I favor individual tips because they're extremely easy to buy. They're cheap. But funds work just as well. One point on tips before we move off of it is that I would favor the 5-year tip over the 10-year tip. And the reason for that is that both have about the same inflation expectation built into them. But with the 10-year TIP, you're also taking on some duration risk. And if your most likely outcome here is that we're going to get a spike in inflation, I'd rather have the 5-year TIP with less duration. And so not have that interest rate sensitivity in my portfolio. So, you know, it's just we're talking about stuff. I'd favor the 5-year over the 10-year.

Is there a macro condition that could change that would adjust your thought there? Is this something that would make you think, geez, we might be in this for a longer haul? I mean, wage inflation, for instance.

The macro thing I'd need to look at is I'd have to feel more confident that longer rates aren't going to continue rising.

Right. Okay. That makes sense. So there are lots of asset classes that are considered to be hedges against inflation. Certainly we've got to talk about gold, but before we do that, I want to take a quick break. And on the other side, we will talk about your thoughts on gold.

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Welcome back to The Way Forward. I'm talking to Chris Cordero, Chief Investment Officer at Regent Atlantic, about inflation. And Chris, we got to talk about gold. As you know, there are very few people who are wishy-washy on that topic. Either it's a brick that doesn't grow and gives you no yield, or it is the only thing protecting us against the evils of fiat money. Where do you come from?

Well, if we're going to Fonzie, I think I'm thick as a brick, if we can go back to Jack's analogies. So the, you know, I look, and gold is really interesting. It is one of those polarizing questions, like, do you like it or not? And for me, gold is a terrific long-term store of value and it does keep pace with your purchasing power. I mean, we have over 2,000 years of pricing history with gold that we can look back on and realize that, you know, what a Roman centurion was paid in gold roughly equates to what a a US Army captain is paid for in dollars today. So gold has basically been a really good way to keep pace with inflation with lots of exciting rides up and down. And it's those exciting rides that really generally don't correspond with inflation that I don't need. So I don't need to introduce more volatility into my portfolio through the use of gold when it's really not a great short-term hedge against inflation. In other words, on the long-term basis, gold's going to keep its purchasing power, so it does help you there. But in the short term, the correlation of gold to inflation changes is just not strong enough to have any type of benefit.

So it sounds like you do not put it in people's portfolios?

I do not put it in people's portfolios.

All right. Yeah, because the other tough question is, if you do, how much is enough to be meaningful but not too much to weigh it down? And that's a tough call, but luckily you don't have to make that. So let's talk about asset classes in addition to TIPS, which you like, that are part of an inflation portfolio. Moving beyond gold to other commodities, certainly we see commodities move in anticipation of inflation. But again, maybe that doesn't correlate well enough for you.

Yes. So the other commodities and more industrial commodities and energy, those do help. And those would be interesting to put in a portfolio. Some of the difficulty now is that a lot of your commodity return when you're buying commodity contracts comes in the form collateral. And when collateral yields are about zero, it makes the overall return from the commodities, you know, it gives it a little bit of a higher hurdle to put in your portfolio. But so we're looking at putting some commodity investments in our portfolios and doing that in a way without precious metal exposure.

And so would you do that? Because as you referenced the contracts, it is tough to buy commodities. Are you going to do it through funds or are you going to—

Yeah, we would do it through funds.

I know that with investors looking at commodity funds, one of the many things they have to consider is are there futures? And also what's the energy weighting? Even if you're in an indexer, if you look at different indexes, the energy weighting is vastly different. How do you sort through some of that stuff?

That's one of the biggest components in what you want to be very specific about. What exposure do you want to energy? And I think that the energy also tends to be a very big component of inflation. So looking for a hedge, you don't want it to dominate the investment, but you'd want to have a— it'd be somewhere around 25% or so.

One specific energy investment that at times has been like all investments, at times has been wonderful and usually unloved times are MLPs, master limited partnerships. A little tricky come tax time, but, but nice yields. What's your thought on that area? And as we move a little bit more toward possibly a lower carbon future, does all energy and especially the pipelines possibly suffer?

My view on MLPs is it's, it's, it's been the asset class that never behaves as you expect it to behave. And so that, that makes it, that makes it really problematic. And I have been, you know, I have had MLPs in our portfolio in the past and I've been disappointed with them because they should not be as highly correlated to the price of energy yet. Yet they tend to be. So you tend to get, you tend to get the downturn when, when oil prices decline. And on the upside, it's not as rosy. So I've been burned there and so I'm not a big fan of them. And I also believe very strongly that our energy use will change over time and has to change. So I know we're talking about inflation right now, but I'm also a big ESG guy. And so it does pain me to put too much fossil fuels in our portfolios.

Gotcha. That's interesting because that raises the issue of utilities, which often can get hurt when bond yields rise because they're sometimes seen as this kind of the equity version of a bond. But on the other hand, utilities will benefit as we move toward a less carbon-intense future because some of their input costs over time will go down. What's your thought about that area?

Yes. And especially energy producers who have relatively low carbon footprints and who are, you know, either have more nuclear or sustainable energy. I believe those are great hedges. And, you know, I think our demand for electricity is going to continue increasing. As, you know, with the whole movement away from fossil fuels?

Yeah, that's a really interesting dynamic. If we're all plugging in our car and everything else, and obviously everyone knows that the device usage, I think, in every household is spiking. We're running out of outlets for all the devices the whole family needs. Let's, let's move to another potential hedge, which is real estate throwing off income, and that income can increase alongside inflation. Are you a fan of real estate? And if so, how do you get exposure to it?

So I think real estate has an important place in people's portfolios. And especially going back to my analogy that tie should go to the runner or the tie should go to the asset that's going to give you some inflation protection. Real estate does that both from the store of wealth because it's actually a physical asset and from the side that rents can increase along with inflation and provide a higher stream of cash flow. So right now how we're implementing real estate is using, and this depends on the client where, but for most clients we're using real estate investment trusts. And the ones that I like a lot are, there are a number of non-traded real estate investment trusts run by high-quality institutional real estate managers. And this is, I look at this as sort of the non-traded REIT 2.0. There were a lot of bad actors in the non-traded REIT 1.0 universe, but now in the non-traded REIT 2.0 universe, you see a lot of high-quality institutional real estate investors. And the benefit to the non-traded REITs are you can get very specific on the asset types that you have in the portfolio. And you get a much better tax benefit than just buying publicly traded REITs. Yeah.

As soon as you said that, the red flag started waving. I mean, it wasn't that long ago that bad actors who gave your industry a really bad name were selling that stuff to clients. But that's interesting that that has changed so much.

Yes. Yeah. And you have really top quality real estate managers who've realized that the non-traded REIT structure has a number of benefits to it that you can't get in a publicly traded REIT.

What kind of yields are you looking at now?

The ones that we're getting between 5% and 6% yield. And because they're in the money-raising phase and putting money to work in properties right now, you're getting a lot of that depreciation on the newer properties flowing through. So, you know, a large part of that dividend yield is return of capital. So it's got a— for a taxable investor to get a 5-and-change yield that's mostly tax-free or tax-deferred is a huge benefit.

Wow. Yeah, that is impressive. So once a year, there's an interesting— I think it's Gallup does an interesting poll where they ask the same question, which is they ask people, what's the best investment? And I can't tell you all the components, but I know gold, real estate, stocks, I think bonds are in there. And if you look at it over time, it's a great contrarian indicator. And it's a great indicator of where sentiment is at that moment. And so people's answers to that question vary a lot, But then when you look at the actual numbers, of course, stocks crush real estate, crush gold over the really long term. And I think the bias mistake we make is you think, wow, my parents bought that home for $20,000, you know, and now it's worth $600,000. But then you realize, oh, that was over half a century. So yeah, so often people point to simple old equities, companies that are growing along with inflation. As a decent inflation hedge. So what's your thought about that part of the portfolio?

[Speaker] Absolutely. I mean, that should— just good old stocks, good companies in your portfolio should be the predominant portion of your equities in the portfolio. That is without a doubt how you should be investing. And if you think about where we are right now in the markets, and if you are a retiree concerned about inflation, you might need to tilt even a little bit more towards equities than fixed income. And that tilt in equities, it should be in just plain old stocks.

So tell us how you get exposure to stocks in your client portfolios, 'cause it's kind of an interesting mix.

So in the base of our portfolios is a portfolio of US large-cap stocks that we run internally. And it is highly tax managed. And so what we're really looking there is we're looking to capture the return of the S&P 500, but do it in a much more tax-efficient manner and have the ability to peel off some highly appreciated issues and use that for our clients' charitable contributions and aggressively harvest tax losses so that we can just really customize the tax aspect of that portfolio. That forms the base. Around that base, we add in other directional bets that we might be making within the market. So right now, those would include a small-cap allocation, those include a value allocation. And so there we'll use will use ETFs or funds to implement that and just tilt that base of the portfolio one way or another based on market conditions.

And so the stock portfolios, those are SMAs?

We manage them internally, so we don't have an SMA manager. So it's just part of the overall, it's what we're doing is similar to what is available in other SMA accounts. But because we're doing it in-house, we don't have an additional fee and we have greater control over how we want to manage the taxes.

Do you have a view on the sectors that make up those large-cap segments right now? You know, obviously we know what's happened to tech. We've seen value take it on the chin for years with what looks like it might be a bit of a comeback now. What are your thoughts there?

Certainly there are some sectors that we like better, especially right now during a rising rate environment, is financials have been really beaten up. And so in a rising rate environment and at the prices that financials are selling at, we see that as a real opportunity. And so, you know, And that would be part of, as I mentioned, we have the base of our portfolio is this S&P tax-optimized portfolio, but where we're looking to take directional bets is more on the value side. And a lot of that is right now in financials.

[Speaker:TREY_LOCKERBIE] And one more question on this theme, and that is dividends. On the one hand, dividend-paying stocks can get hurt once bond yields start getting competitive, with those yields. On the other hand, of course, yields can go up as can the value of the equity. So what are your thoughts on dividend payers?

It's not something that we explicitly look at because you're just looking at high dividend-paying stocks, I think you have to look at the total return and just see, are the earnings there to support the dividend? And so the dividend is really just management decision on how much of their earnings are they going to pay out. Okay. Um, so we, we tend not to focus on strictly that.

Gotcha. Uh, and one more portfolio question, that is, with your clients who are actually in retirement, uh, how are you thinking about a retirement portfolio that is presumably allowing them to maintain their lifestyle but with an inflation issue, as opposed to your 35-year-old client who's got a super long runway?

So we don't change the portfolio allocation based on age or whether they're in a stage of retirement or not, because even the 30-year-old needs some inflation protection in their portfolio. So the— but what I do think is an interesting question is how do you produce that cash flow stream when someone starts needing their portfolio to live on? And from a portfolio perspective and from a planning perspective, I think the best way to do it is just arrive at what's the monthly amount that that portfolio needs to generate. And let's say it's $10,000 a month. We do the math easy. Some amounts of that's going to come from interest and dividends, but it's typically never going to be enough to satisfy the full amount. And so there every month you have an opportunity to rebalance the portfolio and trim a little bit of whichever asset class has done the best over the last month. And in my experience, that's a really sound way of managing a portfolio and producing a stream of cash flow because invariably you're taking the chips off the table of those that have done the best and you're selling high, which is something that eludes lots of investors.

Is it painful though, as some of these, particularly the tech sector, have shot up so much for so long Obviously recently we've had some hiccups, but was it painful during that big run to be trimming back on this?

Not for me personally, because I tend to be a contrarian value type guy. And so for me, I couldn't trim them fast enough. But at the same time, realizing that you needed them in your portfolio and you still need them in your portfolio, even though from a value perspective, I might feel like they're getting stretched It's still, you know, how the world continues on from here, nobody has a crystal ball. So I need them in my portfolio, but I do enjoy taking the profits from them.

Well, that's a nice way to sleep well at night. So we are at time here, Chris. So I just want to, in the Barron's tradition, ask you if you have a final actionable idea for our listeners.

My final actionable idea would be go through your asset allocation and determine where would the tide go to the asset class that's going to give you the best inflation protection and maybe rethink that. So on the bond side, I'd give an edge towards TIPS. On the real estate side, I'd give an edge towards some real estate.

I'm not going to make that my last question because as you were speaking, it occurred to me, what if you're wrong? Well, essentially you've been talking about insurance against inflation. How expensive is that insurance? If it looks like a tie now, is that TIPS exposure very expensive should rates go back down to 1%?

[Speaker:CHRIS_SULLIVAN] So if rates go back down to 1%, I've probably lost the differential between the assumed inflation rate that's in there now of 2.5% and 1%. So I've lost 1.5%. So that, yeah, that would be somewhat painful. But if inflation spikes to 4 or 5, that's going to really benefit. So there is a cost to it.

But the risk-reward is still favorable.

Yeah. On the real estate side, I think less of a risk because if inflation's low, then you're just not getting the inflation bump that you would normally get in any equity appreciation.

Yeah, but your purchasing power remains, right? Chris Cordero, thank you so much for your time. This has been really helpful.

Thank you. It's been terrific.

And thanks to everyone listening. Tune in next week to hear my colleague Steve Sandusky interview Stanford lecturer Matt Abrams on how to maximize your communication skills.

This podcast was brought to you by Wells Fargo Advisors. Looking for a firm your clients can't outgrow? Wells Fargo Advisors offers financial advisors full balance sheet solutions. With wealth planning, investment products, banking, and lending that meet the needs of affluent to ultra-high net worth clients. Build your practice your way and on your schedule with independent and employee model options designed to meet your needs today and tomorrow. Learn more at joinwfadvisors.com.