Goldman Report: Where To Invest in a High Inflation World!

Inflation is running at 7.7 percent in The U.S 10.6 in the EU and 11.1 percent In the UK What's even crazier than this though is The fact that many central banks have Explicitly cited two percent as a Desired inflation Target so does this Warrant a rethink of inflation targets And if it does what assets are likely to Outperform in a higher inflation world That's exactly what was covered in a Recent Goldman Sachs report a report That I will be breaking down for you Today some prime grade Alpha heading Your way guys so don't go anywhere The report I'll be looking into today Was published by James Ashley and Simona Gambarini two Goldman analysts who work For the firm's Global Asset Management Arm It's titled quote is three percent the New two percent sizing up a scenario of Higher inflation targets as I summarize The report I'll be adding some of my own Thoughts along the way So we start here with some background on The methodology of inflation targeting Before the 1990s central banks used an Array of variables to stabilize the Economy these encompassed money supply Targets and foreign exchange rates However since that time there seems to Have been an outsized emphasis on Arbitrary inflation targets

It seems that a general consensus has Evolved around the figure of two percent Inflation For example in the G10 the bank of England European Central Bank Bank of Canada Bank of Japan reich's bank that's Sweden Central Bank and Reserve Bank of Australia all seem to Target this same Arbitrary inflation level The only G10 country that does not have These explicit targets is the United States that's because as many of you Will know the FED has a dual Mandate of Low and stable prices and maximum Employment this is something that the Authors note saying quote inflation has Not been and still is not the single Universally agreed upon right thing for Central banks to Target but according to The authors they do this because merely Agreeing to a strict definition of price Stability would imply zero percent Inflation There are two problems with this of Course one is that you undershoot that Level and tip the economy into deflation This is terrible for economic growth as People don't spend their money when they Know things are getting cheaper This is something that Japan has Struggled with for years a period known As its lost decade The other risk that comes with arbitrary Targeting is that you have to trust the

Actual measure that is used for Inflation the authors note that According to the Boston Commission of 1996 the CPI measure overstates Inflation by about one percent now I'm Personally skeptical about this that's Because if you watched my video on the CPI scam you will see why I think Inflation is being undercounted and not Over counted moreover if you do a bit of Digging into the boskin commission You'll see that the underlying impetus For the report was whether the US was Paying out too much in the form of Social Security benefits and cost of Living support I'll leave links to the Commission in the description for you if You want to read up on it more anyway I Digress the point is that there is Merit In the two percent inflation Target but That doesn't mean we shouldn't consider A change that's because inflation Dynamics in these G10 countries have Changed considerably over the past 25 Years as the authors note the measures Of over or underestimations of the Inflation rate are likely to have Changed as well it's not only that Though structural inflationary impulses Have led to different conclusions as to What the correct anchor price should be These include things like productivity Shifts higher productivity leads to Lower inflation and vice versa

Globalized Supply chains lower inflation When things are running smoothly not so Much when they break and demographic Changes countries in the west have aging Populations which holding all else equal Tends to raise inflation now what all This means is that it may be time to Revisit the two percent Target of course As the authors note it's not as easy as It seems For one there's the risk of losing Credibility for doing so given that Central banks have droned on about the Importance of a two percent Target for Years if they were to immediately move This up to three percent consumers would Have much less faith in those central Banks this would be a further knock to Their reputations already dented by Their having let the inflation Genie out Of the bottle in recent years changing Targets right now could also be a risk For central banks like the fed and Specifically the ECB that's because as The authors note they've made other Changes to their inflation regime the More you change your inflation framework The more it looks like you're moving the Goal posts which of course impacts on The predictability of monetary policy Now the third challenge with Shifting The target is something that all Central Bankers are likely to face and it's Political in nature namely the targets

And mandates that these Central Bankers Have are not determined by them but by Policy makers inflation seems to be on The tip of every politician's tongue and I do wonder how they would react were a Central Banker to come and advocate for A higher inflation Target But whether there will indeed be a Change in the inflation Target is of Lesser significance As the authors point out what's most Interesting is to consider what the Long-term impact of a shift in this Target could be which asset classes are Likely to benefit and what could it mean For long-term risk reward balances Interest rates are perhaps the best Barometer of how the market adjusts to Inflation expectations the most obvious Result of these higher inflation targets Would be a steeper yield curve I.E Investors would expect higher interest Rates for longer term debt to compensate Them for the increasing devaluation of Said debt That's why the authors note that it will Be quote Break Even LED you can see Exactly what that looks like over here a Higher average premium across the term Structure as well as a steeper curve in General on the left is the yield curve Under different economic scenarios with A two percent Target while on the right Are the curves assuming a three percent

Target They do note however that the impact of These changes on the yield Curve will Depend on The credibility of the move These include factors such as the Conditions of the announcement the Inflation history the level of real Neutral interest rates and the fiscal Imperative of higher inflation On top of this there's political Credibility as I've mentioned raising The inflation Target is likely to go Down much more smoothly in those Countries with younger populations Carrying higher debt loads the authors Postulate that those countries that Could have the easiest time adjusting The target up could be the likes of the US and the UK however it could be more Difficult in the Euro area and Japan the Latter having one of the oldest Populations in the world Having said that the authors note that If the ECB were to agree to this higher Inflation Target it could benefit some Of those countries that have higher Credit spreads than others I.E those in Southern Europe as opposed to Western Europe it would inflate away some of the Debt stock so that's interest rates Moving on to other asset classes it's Generally accepted that a higher Inflation Target would be favorable for Risk assets

The author's site a 2019 study by the Peterson Institute which found that Raising inflation targets increases the Scope of rate cutting in future economic Downturns this means that if there ever Was a future Dan turn with a regime Aiming at a higher inflation Target it Would be easier to cut rates and lower Long-term yields both of which can help To Spur growth There is additional theoretical benefit From a higher inflation Target in that It could holding all other variables Equal mean a lower unemployment rate This is thanks to something called the Phillips curve which you can see over Here As the authors note a lower unemployment Rate generally means more growth Okay so we know that a higher Target Could be a boon for risk Assets in General but which risk Assets in Particular While it's true that equities have Tended to beat inflation in the long run In the shorter term it's not as Clear-cut that can be seen in this chart Included in the report For periods shorter than 19 years the Frequency of outperformance is spotty at Best as the authors point out there are A number of reasons for this while it's True that higher inflation means that Producers can charge higher prices

Inflation that is too high can lead to Demand destruction I.E there is a price Level at which consumers will choose to Buy less If a reduction in purchases offsets the Higher revenue from increased prices Well then that's a net negative Another thing to consider is that higher Inflation could also lead to lower Equity valuations that's because Investors May perceive said inflation to Come with a more forceful and Restrictive monetary policy I.E slowing The money printer that said the authors State that they think a three percent Target would be quote sufficiently Moderate and would avoid the downside Implications of demand destruction They also think that with this inflation Level monetary policy is likely to be More supportive in general I.E concerns About hawkish policy are unlikely to Play out Moreover as mentioned previously the Impacts of an economic downturn on Company earnings are likely to be less Severe as there's more room for central Banks to react Now when it comes to which sectors are Likely to benefit from the three percent Target those companies with long-term Fixed liabilities and those that have Revenues tiled to yield curve steepness Are likely to benefit the most

The former are REITs or real estate Investment trusts and the latter are Financials The authors also note that those Companies that have strong pricing power Are likely to be able to increase prices More easily in higher inflation Environments without leading to demand Destruction They also do raise an interesting point Here and that's that those companies Which provide quote innovative solutions That help companies improve productivity And reduce costs could be a prized asset In a slightly higher inflationary Environment Demand for these Services is generally Inelastic in that customers will still Demand them irrespective of higher Prices The authors used an example of medical Procedures for a patient or Advanced Cyber security upgrades for a company Irrespective of what level prices are at People are more willing to pay for these Services quite simply Innovation is a Deflationary force so the higher Inflation is in the longer run the more Companies are incentivized to invest in Innovative Tech solutions that Counteract said inflation Anyways moving on and another asset Class the authors examine is credit Assets

They note that a higher inflation Target Will be largely positive for credit as Spreads are likely to tighten across the Board of course as was the case with Equities the impact will differ According to the sector in question For example insurance companies and Financials are likely to benefit the Most and hence their credit spreads will Tighten the most However those sectors disproportionately Exposed to higher inflation are the Likes of consumer retail and Industrial Their customers are more price sensitive And hence demand destruction is likely The question is whether the growth Component that comes from higher Inflation targets can counteract this The authors also delve into the impacts On credit in different regions I.E Howard Emerging Market credit Fair Compared to developed World credit Etc The tldr is that it's not really clear And I won't delve too much into it right Now That's because this next section is much More interesting it examines the impact That a higher inflation environment Could have on real assets such as real Estate quite simply when coupled with Stronger economic growth real estate Assets will perform relatively well in a Higher inflation environment as the Authors note leases on these properties

Are usually linked to measures of Inflation and if three percent is the New Target then this is likely to Translate into more income and more Valuable assets of course as was the Case with equities and credit the extent To which the inflation pass-through can Be borne out depends on the type and Length of these rental agreements now Looking into other real assets that can Benefit the authors think that Commodities are poised for growth in a High inflation world That's thanks to what they term green Inflation where we'll see much higher Costs for the metals and minerals that Are used to produce environmentally Conscious Tech However something that the authors do Seem to conveniently leave out here is The fact that the environmental impacts Of Mining and transporting these Metals Could in the longer run offset the Benefits of Green Tech that's An Inconvenient Truth right there but I Digress let's move on to arguably one of The most important pieces of this report Which concerns the implications that all This will have on portfolios in other Words what's the best portfolio to have In a world of higher inflation Well firstly how much of an impact does Inflation have on a typical portfolio That's something that the authors have

Evaluated over here with a factor Analysis on risk for a typical UK Multi-asset portfolio the short answer Is not much at all as you can see when It comes to the composition of risk Equities make up close to 95 percent of It after that we have credit and Commodities with only 1.8 percent each And then inflation with only 1.2 percent The same picture plays out when you look At the risk attribution factors Inflation is not a massive contributor To the volatility in a portfolio however As with anything data related past Performance is not indicative of future Returns all of these models were run in A period during which inflation and Interest rates were generally low the Falling interest rates helped to propel A multi-decade bull market for bonds one In which a 40-60 equity fixed income Portfolio delivered about the same Return as a more aggressive 60 40 split This is something shown on the left of This graph over here the cumulative Returns since 2003. however things are Likely to be different in a higher Interest rate environment That's something that the authors have Projected here in this risk return Matrix as you can see a 60 40 split of Equity to bonds produces a 6.2 percent Return versus a 5.2 percent when the Allocation was the other way around

This may not appear that much initially But it becomes much more Stark over the Longer term when you convert it into Real terms I.E subtract the inflation if We were to assume a longer term three Percent Target for inflation the Expected real return would be 2.2 Percent versus 3.2 percent so it's clear That an overweight Equity allocation is A more prudent move in this environment Therefore a well-diversified 60 40 Equity Bond split is a good allocation To Target however the authors do Recommend reallocating capital from Traditional developed market equities And fixed income assets to those which Are likely to perform better in a higher Inflation environment these include Things like small cap equities high Yield bonds Emerging Market debt energy Stocks real estate assets private equity And private credit They illustrate that over here with this Chart which shows the quote real return Focused portfolio Here they've reallocated about 20 from The core assets to the real return asset Classes as you can see based on their Simulations the net result of this is That you have a slightly higher return And higher risk but you also have a Higher sharp ratio For those unfamiliar the sharp ratio is One of the best measures of

Risk-adjusted returns The authors also mentioned that some of The Assets in this portfolio have ESG Considerations but if you've seen our Recent video on ESG investing Trends You'll know that it's a dying narrative That's linked to below by the way Well guys that was an interesting report To break down and I hope an interesting Summary to watch so here are a few of my Quick thoughts to close out Firstly I think it's inevitable That Central banks around the world are going To adjust their inflation targets higher Their credibility has already taken a Knock and they need to be reasonable With targets going forward As the authors of this report have shown There is scope to Target the three Percent level without appearing to be Moving the goal posts Not only that but there could be Long-term growth and employment benefits That come from being more accommodating On the monetary side As we've seen the damage that's been Done to job markets as well as company Earnings by restrictive monetary Policies can't be good for the Pocketbooks of citizens in my view They're doing way more damage than a Slightly higher inflation Target would If we were to see a new monetary regime With slightly higher inflation targets

Then it makes increasingly more sense to Target the 60 40 split if you invest With any sort of asset manager then it Makes sense to add inflation Dynamics to Your due diligence toolbox it's worth Asking them whether they've considered a Scenario of longer term inflation and How this will impact on asset allocation Of course nothing beats doing your own Research you may want to take a deeper Look into your portfolio and study those Stocks that make up the biggest Proportion of your Equity allocation ask Yourself how they would react to a Higher inflation environment do they Have purchasing power do they have a Captive customer or are they producing Innovative Tech and solutions if no then You know if so then there you go And that's it for my video today folks I Hope you found this report helpful I'm Keen to get some of your feedback though Do you think we could see central banks Adjust their inflation targets higher How are you positioning your portfolios Let me know down below while you're down There you may also want to check out my Deals page it's over here where I have Some of the best promos and discounts in The crypto space exclusively for the Viewers of this channel And finally give me a like and a Subscribe on the way out go on you know You want to

Time for this guy to fly so until next Time I'll say goodbye