Anticipating Inflation: An Integrated Multi-Asset Class Approach

Global Portfolio Solutions May 2013 Anticipating Inflation: An Integrated Multi-Asset Class Approach The combination of massive central bank balance sheet expansions and historically low interest rates is driving an interesting shift in the perception of the balance of risks between inflationary and deflationary outcomes. Consequently, now may be a good time for investors to evaluate how their portfolios might perform in various inflation scenarios. In this paper, we discuss our framework for evaluating inflation-sensitive exposures, as well as our approach for incorporating these real return exposures in a multi-asset class portfolio. The Case for Inflation-Sensitive Returns Before exploring the components and combination of real return exposures in a portfolio, it is important first to understand the current environment and how the inflation outlook could change. On the most basic level, inflation can be driven by either disequilibrium between demand and production capacity, or by monetary policy mistakes. Specifically, these drivers can be labeled as Limits-to-Growth, Commodity Bottleneck, and Monetary Policy (Exhibit 1). EXHIBIT 1: DRIVERS OF INFLATION Limits-To-Growth Commodity Bottleneck Monetary Policy Demand-pull inflation Faster than expected return to growth that drives rising wages and increasing consumption and prices Cost-push inflation A shock to existing supply or limited production capacity of a scarce resource Changes to the money supply, which drives intentional or unintentional inflation Of the three drivers, recent monetary policy actions by central banks around the world have received the most attention. In the US, given the sheer size of policy intervention, the Fed is in uncharted waters in terms of how and when to reduce this intervention. Before the financial crisis, monetary policy was largely a matter of adjusting the overnight policy rate target based on the amount of slack in the economy and setting inflation expectations. However, with the policy rate at zero for more than four years, the Fed has had to use non-traditional tools to execute its monetary policy: purchasing assets, adjusting the maturity of its asset holdings, and paying interest on excess bank reserves. While we believe the Fed likely has sufficient tools to maintain inflation at desired levels, these strategies are relatively untested. Policymakers have limited experience with many of the non-traditional tools being used, and the efficacy of these tools is not certain. Furthermore, there are several compelling reasons as to why the Fed may choose to allow inflation to materialize at higher levels than we have experienced in recent years. First, there remains significant debt (household and federal) overhang, and there may be potential benefits to inflating it away. Second, running the economy at the current inflation target may have left the US uncomfortably close to a liquidity trap. 1 Third, if the current political impasse continues in Washington, D.C., with little likelihood of addressing the US fiscal situation, the Fed may resist raising rates in order to limit any increase to the federal government s interest expense. Similarly, we are still waiting to see the longer-term consequences of recent monetary policy actions in the UK, Europe, Japan, 1 A liquidity trap is defined as a situation in which short-term nominal interest rates are low and, as a result, the efficacy of monetary policy actions is diminished. Goldman Sachs Asset Management 1

and China. However, putting aside concerns in certain pockets of the European periphery, deflationary pressures appear to have been reduced, particularly in the US, while the prospect for higher inflation has become a somewhat bigger question mark (Exhibit 2). EXHIBIT 2: EFFECTS OF MONETARY POLICY ON REAL RETURN ON CASH 2 Rate or Return (%) 20 15 10 5 0 Late 1960s Growth-driven inflation as spare capacity vanishes ( Limits-to-Growth inflation) 1973 Commodity prices rise sharply due to OPEC cartel ( Commodity Bottleneck inflation) Late 1970s Fed policy missteps ( Monetary Policy inflation) -5 CPI-U Rolling 12-Mo Rate Rolling 12-Mo Real Return on T-Bills -10 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010? Compounding the uncertainty driven by monetary policy is the uncertainty stemming from globalization and changing trade patterns. For many years now, economies in emerging and growth markets have been a global disinflationary force, essentially exporting low-cost labor to the major consumer economies. Going forward, it is unlikely that these pressures will be as strong as they have been in the past decade. We do not believe that inflation in the US is likely in the near-term; it is not our central case. After all, inflation remains low and the Fed appears more focused on defending against downside risks than upside risks to its 2% inflation target. However, it can certainly be argued that the risk of inflation and the potential range of inflationary outcomes seem larger today than they have for many years and may be skewed towards higher inflation. As the wait and see dynamic within the global economies continues, it may be prudent for investors to either shore up inflation-sensitive exposures or to build a set of exposures that seeks to provide a multi-asset class portfolio with diversified, inflation-sensitive, risk-adjusted returns. Identifying Real Return Exposures In the context of inflation-sensitive components of a multi-asset class portfolio, we have found that investors tend to follow one of several approaches: exposures seeking to generate inflation-aware returns over the long-term across all macro economic environments ( CPI + 5% exposures ), exposures with concentrated investments that are specifically sensitive to the three drivers of inflation ( real return exposures ) and inflation hedging strategies that attempt to generate a high payout if a particular inflation scenario manifests itself in short order (Exhibit 3). 2 CPI-U = Year-over-year change in the Non-Seasonally Adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U), published monthly by the Bureau of Labor Statistics. Rolling 12-Mo Real Return on T-Bills = Realized return on investments in US Treasury Bills less the year-over-year change in CPI-U. The labels of inflationary epochs describe what we believe to be the most important driver of inflation during each period. Actual drivers of inflation can be complex, may come from multiple sources, and can be hard to identify with precision. Source: U.S. Bureau of Labor Statistics, BofA Merrill Lynch, U.S. Federal Reserve Board, and Goldman Sachs. Time period was chosen based on longest common period available for the two sets of time series data. Goldman Sachs Asset Management 2

EXHIBIT 3: INFLATION-SENSITIVE COMPONENTS OF A MULTI-ASSET CLASS PORTFOLIO 3 CPI + 5% Growth Real Return Growth Inflation Growth Inflation CPI + 5% Exposures Inflation Real Return Exposures Inflation Diversified exposures seeking long-term inflation aware returns across all macro economic environments We look to allocate across asset classes and risk factors, which do well in different environments Investments that benefit from rising real cash flows in rising inflation Exposure to inflation-sensitive assets across sectors (i.e. fixed income, commodities, private assets) Investments in assets that are expected to maintain or increase in value for the duration of a specific inflation threat CPI + 5% exposures draw from a wide spectrum of asset classes and exposures, including global equities, fixed income, commodities, and alternatives. Real return exposures which we focus on in this paper comprise more focused asset classes that benefit from rising real cash flows in high or rising inflation environments. These inflationsensitive, real return exposures should include select equity sectors, fixed income, and commodities, so long as the exposures have the desired inflation sensitivities (Exhibit 4). EXHIBIT 4: IDENTIFYING REAL RETURN EXPOSURES 4 Equities: S&P 500 Index Fixed Income: Market Cap Weighted Portfolio Energy Materials Cons Staples Health Care Utilities Telecom Industrials Information Technology Financials Cons Disc High Yield EMD Treasuries Govt Related Corporate TIPs MBS, CMBS, & ABS EMDL Bank Loans Commodities: S&P GSCI Index Private Assets* Energy Precious Metal Agriculture Ind Metal Live Stock Energy Dist./ Manufacturing Healthcare Real Estate & Mining Services Telecom Tech Media & Entertainment Financial Serv. Retail / Cons Prod Other 3 For illustrative purposes only. Source: GSAM. There is no guarantee these objectives will be met. 4 Source: Bloomberg, Cobalt, GSAM. *Private Assets Universe is consistent with the sector break out used by GSAM Private Equity Group. Goldman Sachs Asset Management 3

We map these asset classes against the three drivers of inflation. A Limits-to-Growth shock (a continuing trajectory of economic expansion that drives the utilization of spare capacity) would spark inflation if the estimates of spare capacity were incorrect. In such a scenario, growth assets, like equities, may perform well initially, especially those sectors deemed to have pricing power. Commodity bottlenecks naturally raise commodities prices and, to a lesser extent, the performance of commodity producers. Lastly, in a case where quantitative easing fails to generate growth but drives a material increase in inflation expectations, or if the Fed s exit policy fails, fixed income asset classes with shorter duration and / or whose coupon streams are linked to inflation, may be best-positioned for rising inflation (Exhibit 5). EXHIBIT 5: POSITIONING FOR REAL RETURNS 5 Limits-To-Growth Consumer Staples Equity Healthcare Equity Energy Equity Materials Equity US REITS US MLPs Global Infrastructure Energy Private Equity Private Infrastructure Private Real Estate Farmland Commodity Bottleneck Commodities Equities of commodity producers Monetary Policy Opportunistic Credit Bank Loans US TIPS FX Carry EMDL Identifying Suitable Assets for Real Return Exposures Equities We believe that while equities tend to be inflation-sensitive as a whole, it is important to identify equity sectors that represent enterprises with either a high percent of historical capital investment (financed by long-term debt) relative to labor and commodity costs, or a revenue stream where price is potentially linked to inflation while demand for the product is relatively inelastic to both price and real economic growth. Specifically, we believe five equity sectors represent good fits for this profile (Exhibit 6). EXHIBIT 6: EQUITY ASSET CLASSES Equity Asset Class Equities of Multi-national Commodity Producers Local REITS (and other real estate) Local Infrastructure Consumer Staples Healthcare Inflation-sensitive Characteristics Revenue driven by commodity prices creates inflation sensitivity to price Current global demand to many commodities is relatively inelastic to real growth conditions Income from rents rises with inflation Revenue related to transportation or delivery of staples such as water or energy (extension of REITS) Revenue rises with inflation while demand is relatively inelastic due to pricing power Pricing power Inelastic demand 5 Source: Global Portfolio Solutions. For illustrative purposes only. Goldman Sachs Asset Management 4

Fixed Income Real return fixed income investments include those with coupon streams that are either explicitly or implicitly linked to inflation, and are relatively less sensitive to potential increased probability of defaults (Exhibit 7). EXHIBIT 7: FIXED INCOME ASSET CLASSES Fixed Income Asset Class TIPS Collateralized Floating Rate Bank Loans Offshore Unhedged Debt Short Duration Opportunistic Credit Inflation-sensitive Characteristics The principal of a TIPS contractually increases with inflation, as measured by the Consumer Price Index Floating rate coupon creates inflation sensitivity as rates tend to rise with inflation over a business cycle Domestic currency tends to depreciate with rising inflation, creating linkage to inflation in income stream Low duration results in low sensitivity to rising rates while credit spreads provide returns (as investors demand real returns for taking credit risk) Other fixed income sectors may also perform well in some inflationary scenarios. For example, floating rate nonagency mortgage securities have limited interest rate risk and a return profile that is closely tied to changes in home prices. Houses are a real asset that should appreciate in value in an inflationary environment, which could benefit nonagency mortgages. High yield corporate bonds represent another fixed income sector that tends to perform well in stronger growth scenarios due to the positive effects of growth on corporate credit quality. Asset managers are increasingly offering exposure to these sectors via strategies that can hedge the interest rate risk and shift sector allocations over time as the environment changes. Commodities Commodity exposures tend to be a significant component of inflation benchmarks, and we believe it prudent to focus on a balanced set of commodities that represents a close facsimile of the components driving a CPI target. It is also important to consider the type of commodity exposure in the context of real returns: we believe that while passive commodities can be effective in scenarios where there is a demand/supply bottleneck, actively managed commodity strategies can potentially contribute to portfolio returns in terms of relative value calls. A Word on Private Real Return Assets While this paper focuses on public assets, we believe that private investing could represent another way of gaining exposure to real assets. Private real asset market exposures tend to access betas and investment opportunities that are not available in the public markets, and importantly, manager-specific skills in certain sectors can provide differentiated return contribution. We believe the following sectors are worth investor focus in the context of private real return assets: Energy: particularly in US, significant activity in smaller-sized private opportunities that can benefit from skilled management with experience in the field Infrastructure: often, and particularly in the US, non-energy infrastructure can only be accessed in private markets Private Real Estate: only a relatively small fraction of the real estate market can be accessed in the public market Farmland: a segment of real estate with a commodity beta that is not available in public markets; accessing these investments can be challenging even in the private markets as limited historical data and manager experience in this space reduce confidence in this sector Goldman Sachs Asset Management 5

Bringing It Together: Sizing Real Return Exposures in a Multi-Asset Class Portfolio By aligning potentially appropriate asset classes by inflation driver, we are able to define the universe of exposures and begin our evaluation of how to combine these exposures as a Real Return component in a multi-asset class portfolio. These exposures, when incorporated, would seek to contribute diversified risk and returns characteristics across various inflation scenarios. Sizing real return exposures should begin at the portfolio level, where our approach uses risk-budgeting to construct an illustrative multi-asset class portfolio. This approach budgets risk across a suite of risk factors instead of allocating capital across asset classes. 6 In the context of real return exposures, we set out to budget comparable risks across the three broad buckets of inflation drivers, such that the resulting combination has a relatively diversified exposure to our portfolio risk factors (Exhibit 8). EXHIBIT 8: REAL RETURN COMPONENT OF AN ILLUSTRATIVE MULTI-ASSET CLASS PORTFOLIO 7 Illustrative Multi-Asset Class Return-Generating Portfolio Real Return Exposures: Capital Allocation Fixed Income / Other 25% Alternatives 39% Equities 24% Real Return 12% Diversified Commodities Cash & Risk Management 0.2% REITS Energy & Material Eq. Consumer Staples Eq. Healthcare Eq. Global Infrastructure MLPs Real Return Exposures: Factor Decomposition Commodity Bottleneck 1.5% Limits-to-Growth 4.6% Global Developed Equity Factor Emerging Markets Factor Rates Factor Credit Factor Volatility Factor Commodities Factor Currency Factor Diversification Benefit -10% -5% 0% 5% 10% TIPS Bank Loans Opportunistic Credit Emerging Market Debt Local Monetary Policy 5.2% This framework for selecting and incorporating real return exposures could be used by investors seeking to position their portfolios for a range of inflation scenarios over the medium to long term. 6 Please see our April 2013 paper on our approach to asset allocation: The Road to Factor-Based Risk-Budgeting. 7 All numbers reflect Global Portfolio Solutions strategic assumptions as of a certain date. Strategic long-term assumptions are subject to high levels of uncertainty regarding future economic and market factors that may affect future performance. They are hypothetical indications of a broad range of possible returns. Please see additional disclosures. Please refer to the appendix for our strategic long-term assumptions. The portfolio risk management process includes an effort to monitor and manage risk, but does not imply low risk. Goldman Sachs Asset Management 6

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