June 27, 2011

PIMCO Expert on Inflation: ‘Goldilocks Days’ Are Over

Portfolio manager shares ways to invest in a world with rising commodities and other prices

PIMCO's Mihir Worah says that it’s time to wake up and understand the new dynamics affecting inflation in 2011 and beyond, which he explained in a commentary piece for the fund group on Monday. Overall, he expects inflation to average between 3% and 5% a year worldwide.

Worah (left) says “the goldilocks days of the '90s,” when countries could have both strong economic growth and low inflation at the same time “are gone.” While in the ‘90s and afterward, emerging markets could export disinflation to developed markets, the situation today is “turning around” as emerging markets go through “a particularly commodity and energy intensive phase of growth,” the portfolio manager explains.

“Inflationary pressure from commodities will be even higher within emerging markets … [since] commodities are such a large part of their consumption basket – for example, nearly 60% in India, compared to about 25% in the U.S.,” he wrote in an opinion piece released by PIMCO on June 27. 

“Rising commodity prices along with reflationary policies from many developed-market central banks should result in modestly higher inflation going forward,” Worah added. “We expect developed market inflation to average about 3% and developing market inflation to average about 5% over the secular horizon.”

Another factor driving inflation today is that policymakers in the developed world are expected to “make their economies more competitive via a cheaper currency, which likely will, for net importers like the U.S., lead to higher inflation,” said Worah, who trained as a physicist.

As emerging economies cope with their own inflationary pressures, they may follow let their currencies appreciate. “This is another channel by which emerging markets may export inflation to developed nations that buy their goods,” the PIMCO real-returns guru explained.

Still, Worah notes, he and other PIMCO experts do not predict “an inflationary spiral resembling the 1970s.” Thirty years ago, there was less faith in central banks and unions had more power. “The situation is different today,” he said.

Investment Strategies

As for what investors can expect by investing in commodities, Worah says that this asset class has given investors a positive real rate of return – a return above inflation. “The main risk would be to not understand that commodities are a volatile asset class; prices will not go up in a straight line and there could be periods of negative returns,” he explained.

That said, many investors are under-allocated to commodities, in his opinion. “So just making the basic investment in commodities could potentially provide them a hedge against inflation, and that is the primary benefit,” the analyst shared.

The two commodities that best fit this bill? Crude oil and copper. “Both of them are strongly connected to global growth and emerging market growth in particular. And both have significant supply constraints such that, if demand growth continues at the same pace for the next couple of years as it has been, we could see significant supply shortfalls,” he wrote.

Worah is bullish on inflation-linked bonds, because “one way for developed markets to escape from their debt overhang is by artificially keeping real rates low.” Thus, inflation-linked bonds “have the potential to hold their value while serving as a cornerstone of an inflation-hedging strategy”.

In addition, the PIMCO portfolio manager argues that now is not the time to be passive. “[In] this environment, investors are ill-served by passive strategies that lock in these low real rates of return,” he shared. Instead, they should seek out “prudently managed active strategies that provide the benefits of inflation-linked bonds while attempting to enhance the offered yields.”

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