How can Inflation Expectations affect your Portfolio Risk?
Yannis Sardis, 1 June 2021
According to a recent Bank of America Merrill Lynch (BAML) Global Fund Manager Survey, 69% of the participants expect above-trend inflation (and growth) to persist in the future. According to the same survey, the biggest ‘tail risks’ for markets going forward are increased inflation (35% of the audience), followed by a higher probability of a ‘taper tantrum’, i.e. a spike in U.S. Treasury yields, if the Federal Reserve gradually put the brakes on its QE program (27%), and the extension of multi-asset bubbles (15%).
Are Wealth Managers and Family Offices prepared to weather such occurrences, especially if inflation proves to be more than a ‘transitory’ consequence of the elevated post-COVID consumer spending? Notably, the BAML survey cites COVID-19 as the fourth most probable tail risk, with a mere 9% of the participants being concerned about it.
As we have discussed in the past, portfolio modelling can include a wide range of risk factors against which a multi-asset portfolio can be stressed and revaluated. The risk factors to be chosen, largely depend on the portfolio’s asset structure and instrument composition, and can include:
- Interest Rates, for holdings the valuation of which depends on Interest Rates
- Interest Rates Term Structure, for portfolios with Fixed Income holdings
- FX Rates, for holdings denominated in currencies other than the base currency
- Index Rates, for holdings linked to an Index, such as Inflation Linked Bonds or Index-Tracking Funds
- Price Time Series, for equity-like instruments, such as stocks and Exchange Traded Funds.
However, a versatile risk management software solution can also accommodate Custom Stress Testing analysis, based on market and/or macro-economic factors that may affect a portfolio’s risk and valuation indirectly. Such a flexibility empowers money managers to tailor the scenarios to their portfolio-specific conditions and ensure the adaptation of their investment decisions to current market conditions and driving factors.
Insofar the user of the portfolio risk engine can match a representative market index to a given macro factor (such as assigning a CPI benchmark to the inflation factor), the system can run its analysis and assess the impact of any macro factor changes (e.g. inflation) on the reference portfolio, namely its adjusted Value at Risk and Market Value.
To facilitate such a multi-factor analysis, the risk system estimates the correlation between the time series of the nominal interest rates that are affected by the increase in inflation projections and the time series of the portfolio holdings (such as equities, bonds, commodities), at any granularity (e.g. asset class, sector, geography level). Such a scenario simulation ability allows money managers to customize their cross-correlation matrix in a way that incorporates their own prevailing views.
In conclusion, as long as one can select a relevant, to the macro factor in question, listed index with a price history, the risk engine can produce the portfolio’s amended risk metrics and market valuation. For example, in addition to inflation expectations, the users could simulate the behavior of their strategies due to Yield Curve changes.
Such stress testing methodologies have allowed our clients to develop diverse investment strategies that reflect weaknesses or opportunities in hypothetical adverse market conditions.
FINVENT Software Solutions is a provider of financial software applications and custom engineering services. The award-winning KlarityRisk platform specializes in investment risk analytics and fixed income performance attribution reporting, and it is offered to Private Wealth institutions, Asset Managers, Hedge Fund Managers and Family Offices.
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