WHAT TO EXPECT WHEN EXPECTING

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1 PILOTAGE PRIVATE WEALTH AG MARCH 015 The fundamental question when making any investment is always how much extra expected return do I require for my expected risk?

2 Why are inflation expectations so important? The fundamental question when making any investment is always how much extra expected return do I require for my expected risk? While the expected risk and expected return inputs among market participants are widely varied, the benchmark of almost any asset starts with the risk-free rate (typically three-month US Treasury Bills), plus a premium to compensate for expected risk. The yield on a risk-free instrument is made up of two components: the inflation adjusted yield (otherwise known as real yield ) plus expected inflation. On Chart 1: 7% 7 % 5 5% % 3 3% % Inflation Expectations Over Time Expected Inflation one-year Expected Inflation five-year Expected Inflation ten-year this basis, the market s expectation of future inflation underpins the benchmarking and subsequently, pricing of nearly every security and asset class in global capital markets. With inflation expectations so low across most of the developed world, we explore the contributors to, and accuracy of, these expectations. Chart 1 highlights the trend in one-, five-, and ten-year inflation expectations since 198. Measurements To measure this, we take the longestavailable inflation expectations series from the Cleveland Federal Reserve. This series is compiled by combining the market-implied inflation expectations from a number of securities. These securities include inflation swaps, interest rates, and inflation-linked securities (TIPS). We will examine how these inflation expectations are intertwined over three timeframes: one, five and ten years. 1 1% Jan 8 Jan 8 Jan 90 Jan 9 Jan 98 Jan 0 Chart : 7 % 5 % 3 % X Year Inflation Expectations vs X Years Trailing Inflation 8% 1y Expected Inflation (y) vs 1y Trailing Inflation (x) 5y Expected Inflation (y) vs 5y Trailing Inflation (x) 10y Expected Inflation (y) vs 10y Trailing Inflation (x) 1 0 % % % 8% 10% Recency Bias Policy-makers are well aware that inflation expectations can become dangerously self-reinforcing given they are largely informed by recently experienced inflation. This view is confirmed by the correlation between expected (future) inflation and experienced inflation (see Chart ). The correlation between one-, fiveand ten-year inflation expectations to one-, five- and ten-year trailing inflation respectively are 7%, 85% and 91%. This relationship can be seen in Chart 3. This strongly suggests that what we ve just experienced is mirrored as the expectations of the future. This /5

3 phenomenon can be found in every facet of capital markets be it volatility, economic growth or equity market performance forecasts. Efficacy Knowing that current inflation informs our expectations for the future, should we put any weight in these forecasts? For this manner of analysis to be effective, future inflation would have to look a great deal like past inflation. Below we test to see if this framework holds any water. Chart 3: 8 1y Expected Inflation (y) vs 1y Forward Inflation (x) X Year Inflation Expectations vs Actual Inflation X Years Forward 5y Expected Inflation (y) vs 5y Forward Inflation (x) 10y Expected Inflation (y) vs 10y Forward Inflation (x) Spoiler Alert: The relationship between future and expected inflation is not so good especially in the shortterm. The correlation between one-, five- and ten-year inflation expectations to one-, five- and ten-year forward realized inflation respectively are 38%, 53% and 83%. While 83% is quite a high correlation, it must be examined where this comes from and if it is a useful forecasting tool. The 83% correlation coefficient on the ten-year horizon fails to capture the fairly consistent error in the future inflation expectations. Namely, as long as the over- or under-estimation is consistent, the correlation coefficient can be 100%, but not be accurate at all. In fact, historically, the median overestimation of inflation averaged 0.71% per year. This is a large sum, particularly when: a) inflation has averaged 3.% since 197; and b) 0.71% is compounded over ten years. 8 Chart : Correlation of Inflation Expectations Over Time 8 1y Expected Inflation (y) vs 5y Expected Inflation (x) 1y Expected Inflation (y) vs 10y Expected Inflation (x) 5y Expected Inflation (y) vs 10y Expected Inflation (x) 8 Low dispersion of estimates across timeframes The correlation between inflation expectations across timeframes is particularly strong (as shown by Chart ). The lowest correlation exists between the one-year and five-year inflation expectations at 97%, and 99% between five-year and ten-year expectations. The similarity is a possible source of over/ under-estimation of inflation, it is also a nod at behavioral bias we all exhibit called Recency Bias; the tendency to project current experiences far out into the future. Logically, one would not expect the economic environment today will be the same as ten years in the future. Yet this is exactly how shortterm and long-term inflation expectations have clustered. The reason for why expectations on one timeframe would 3/5

4 bleed so much into the others is perhaps the subject of future study. Conclusion While inflation expectations are vital to investment success, the market seems to do a poor job of forecasting it. Our practical understanding of the drivers of inflation remains a work in progress. While inflation has been consistently over-estimated in the Cleveland Federal Reserve s series, the sample may be biased by the overall downward trend of inflation. Because Recency Bias is so clearly evident, it seems likely that serial under-estimation would also be possible when a period of very low inflation transitions into higher inflation. From a portfolio perspective, the main take away is that one must hold a variety of assets to be able to provide a positive return in a variety of inflationary outcomes. This diversification is critical, given how often markets misprice inflation and, subsequently, assets. /5

5 Pilotage Private Wealth AG (PILOTAGE) is an SEC Registered Investment Advisor in the United States of America and is a member of ARIF in Switzerland. Registered office at Lintheschergasse 3, 8001 Zurich, Switzerland. The sole purpose of this document is to inform, and it in no way is intended to be an offer or solicitation to purchase or sell any security, other investment or service, or to attract any funds or deposits. Investments mentioned in this document may not be suitable for all investors. Before making any investment, each investor should carefully consider the risks associated with the investment and make a determination, based upon the investor s own particular circumstances, that the investment is consistent with the investor s investment objectives. Although information in this document has been obtained from sources believed to be reliable, PILOTAGE does not guarantee its accuracy or completeness and accepts no liability for any direct or consequential losses arising from its use. The information contained herein is not intended to be an exhaustive discussion of the strategies or concepts mentioned herein or tax or legal advice. Readers interested in the strategies or concepts mentioned herein should consult their tax, legal or other advisors, as appropriate. Opinions expressed herein may differ from the opinions expressed by other affiliates of PILOTAGE and are not intended to be a forecast of future events, a guarantee of future results or investment advice, and are subject to change based on market and other conditions. In any event, past performance is no guarantee of future results, and future results may not meet our expectations due to a variety of economic, market and other factors. Further, any projections of potential risk or return are illustrative and should not be taken as limitations of the maximum possible loss or gain. Neither PILOTAGE nor any of its affiliates can accept responsibility for the tax treatment of any investment product. PILOTAGE assumes that, before making any commitment to invest, the investor and (where applicable, its beneficial owners) have taken whatever tax, legal or other advice the investor/ beneficial owners consider necessary and have arranged to account for any tax lawfully due on the income or gains arising from any investment product provided by PILOTAGE. At any time, PILOTAGE or its employees may have a position, subject to change, in any securities or instruments referred to, or provide services to the issuers of those securities or instruments. This document may not be reproduced or circulated without our written authority. The manner of circulation and distribution may be restricted by law or regulation in certain countries. Persons who come into possession of this document are required to inform themselves of, and to observe, such restrictions. Any unauthorized use, duplication or disclosure of this document is prohibited by law and may result in prosecution. Pilotage Private Wealth AG is a Swiss based, SEC registered, independent wealth and asset management practice that partners with US clients to deliver bespoke global investment strategies. In an increasingly complex world, we guide our clients through US cross border challenges to provide a transparent and consolidated approach to multi custody, multi jurisdiction and multi asset strategies. From generational wealth preservation to asset diversification to philanthropy, PILOTAGE delivers a unique global perspective to capital allocation and risk management in a tax-efficient framework. Our team of experts come together to continuously refine our client s experience to ensure their values are preserved. Geneva 7 Rue Versonnex 107 Geneva Switzerland Zurich Lintheschergasse Zurich Switzerland T: F: E: enquiries@pilotage.ch W: 5/5