Understanding the Risks of Inflation
Traditional Risk Models Miss the Root Causes of Inflation
SEP 1, 2021
Financial advisors are leaning on risk models that point to the past to predict the future. That’s a problem when you consider that the most meaningful risk we experience today has no precedent.
Take inflation. Any risk model that uses history to analyze the present will miss the root causes of inflation — where it’s coming from, how it’s likely to take shape, and how it will affect your investments.
If a legacy risk model could talk, it would say: “Wait a second. Inflation has tons of precedents! What about Weimar Germany? Greece in 1944? America in the 1970s?” And the risk model would be wrong — because the economy that’s behind today’s inflation has nothing in common with the past. Here are three ways the environment has changed.
1. Globalization has created a web of interdependencies
The financial markets are globally integrated now. Thousands of risk factors (that an asset class lens will miss, by the way) have reverberations that are hard to predict. For example, we have an integrated credit system, where changes to bond issuance and credit will have outsized impacts on the financial markets.
2. The market structure is more complex
Inflation is more complex today because the environment is more complex. Risk models based on asset classes see the world through a linear lens. This happens, then this happens. There’s a pandemic and equity markets go down. There’s a stimulus package and they go up. But inflation takes a winding path as it moves through the environment, settling into all the corners. It shows up at the gas pump, in our bonds, in our retirement plans, and our timelines for buying a home.
How can we understand how inflation will affect our portfolios?
Financial advisors are stuck using a standard asset class lens to look at risk. You’re defining exposure based on the types of companies in your portfolio: their geographies, their market caps, their equity exposure, and so on.
A risk factor lens can see the tugs and pulls in the web and make forecasts about its final shape. It will see how inflation effects will differ for the brick-and-mortar industries versus those that traffic in intangibles; how small cap stocks with limited bargaining power will fare versus a high cap stock that rules the roost; how emerging countries producing commodities will be affected compared to the developed countries that consume them.
It’s no wonder why big institutions use risk factors to make predictions. At Fabric, we want to bring risk factors to you, the financial advisor, and make the fabric of the financial universe visible and accessible to everyone.
Scenario risk has two components, the event itself, and the vulnerability of the market to that event. An event is going to be worse both in the size and the speed of the drop and if the market is highly leveraged, more concentrated or less liquid.
Access a better way to understand and work with risk, powered by MSCI’s factor model.
CO-FOUNDER AND HEAD OF RISK
Rick Bookstaber has held chief risk officer roles at major institutions, most recently the pension and endowment of the University of California. He holds a Ph.D. from MIT.