Building an Inflation-Proof Portfolio | Systematic Investor | Ep.384

Episode Overview

• This episode explores the critical transition from a global economy built on efficiency and "just-in-time" supply chains to one focused on security and redundancy.
• The guests argue that the traditional 60/40 portfolio is broken because bonds no longer serve as a reliable hedge against equities in a high-inflation environment.
• It provides a specific framework for constructing a "defensive anchor" for your portfolio using a mix of bonds and commodity trend following to survive supply-side inflation.
• The discussion covers the mechanics of "sticky" inflation, the impact of the green energy transition, and why active management is superior to passive holding for commodities.

Key Concepts

• The Structural Shift from Efficiency to Security Global trade is moving away from cost-saving "just-in-time" models toward "just-in-case" inventories due to geopolitical tension and a loss of trust. This shift is inherently inflationary because building redundant supply chains costs more money, replacing the deflationary tailwinds of the last few decades with inflationary headwinds.

• The Breakdown of Bonds as a Hedge For 40 years, bonds protected portfolios; when stocks fell, bonds usually rallied. In the current high-inflation regime, this negative correlation breaks. Bonds begin to offer negative real returns ("CPI minus") and become positively correlated with equities, causing both sides of a traditional 60/40 portfolio to fall simultaneously.

• Commodity Trend as the "Anti-Bond" Commodity trend following is presented as the functional opposite of bonds. While bonds suffer during inflation, commodity trend strategies thrive on the price volatility caused by supply shocks (e.g., energy shortages, food scarcity). It captures the upside of inflation that hurts the rest of the portfolio.

• The "Defensive Anchor" Portfolio Construction To solve the 60/40 problem, the guest proposes a new building block: 50% Bonds combined with 50% Commodity Trend. This mixture aims to deliver "CPI + 4%" in all environments. The bonds work during disinflation/deflation, and the commodity trend works during inflation/supply shocks, creating an "All-Weather" defensive core.

• Autocorrelation and Market Physics Trend following works best in markets with positive "autocorrelation" (past price moves predict future moves). Bonds and commodities historically show high positive autocorrelation, making them ideal for trend strategies. Equities often exhibit mean reversion (choppiness), which explains why trend following often struggles to harvest returns in pure stock markets.

• The Asymmetry of Inflation Historical data suggests inflation is "sticky." It tends to spike rapidly due to shocks but takes a long time to drift back down. Markets currently pricing in a rapid return to low rates are likely wrong; central banks may need to keep policies restrictive for longer than investors anticipate.

Quotes

• At 0:06:14 - "Focusing on building robust portfolios that may not give you the highest returns, but will get you through the next five, seven years safely will be the key thing." - Niels Kaastrup-Larsen emphasizing survival and robustness over maximizing yield in uncertain times.
• At 0:15:05 - "We see each country becoming more interested in securing its own supply chain... sacrificing the efficiency of super tight supply chains to try to get more security because as you say, trust is gone." - Yoav Git explaining the inflationary structural shift in global economics.
• At 0:20:19 - "Once you start looking at rising inflation, bonds start to underperform... and as you reach proper inflation... you have a situation where bonds are not only strongly negative... but also they become much more correlated to equities." - Yoav Git detailing the mechanics of why the 60/40 portfolio breaks down in inflationary regimes.
• At 0:21:38 - "If you put a portfolio like simply a 50% commodities, 50% bonds, you get something which is truly All-Weather. What it does, it gives you CPI plus 4% in all environments." - Yoav Git simplifying the solution for a defensive portfolio allocation.
• At 0:25:06 - "Inflation spikes much more quickly and then takes a little bit longer to come down. So it actually spends a little bit more time coming down, it's stickier." - Explaining why investors should not expect a quick return to low interest rates.
• At 0:29:30 - "Supply shocks... drive commodity trend... If you have less storage and if you have a constrained supply... suddenly when there is a cold spell in the US, suddenly you're going to start seeing big, big trends in natural gas." - Yoav Git connecting real-world physical constraints to the performance of trend-following strategies.
• At 0:29:52 - "If you were to look at a mixed portfolio of bonds and commodity trend, what you get is something which is resilient to either environment." - Highlight the diversification benefit of combining assets that react differently to inflation.
• At 0:42:24 - "Commodities are a beautiful diversifying asset class... and I think that the dynamics are very, very different to the dynamics in the financial universe." - Emphasizing why commodities are essential for true portfolio diversification beyond stocks and bonds.
• At 0:47:59 - "If you have a Sharpe of one in your underlying asset... you will get maybe 0.8 Sharpe into your P&L of your trend following system." - Explaining the "smile effect" where trend following captures a significant portion of an asset's underlying performance.
• At 0:52:43 - "Negative autocorrelation... translates into a lower performance, so you're not able to harvest... using a generic trend following machinery, you will be able to get less trend." - Clarifying why choppy markets destroy trend-following returns.

Takeaways

• Abandon the reliance on the traditional 60/40 portfolio structure; in an inflationary world, you must introduce assets that are negatively correlated to stocks and bonds.
• Implement a "defensive" allocation that pairs Fixed Income with Commodity Trend strategies to hedge against both deflation (bonds win) and inflation (commodities win).
• Avoid passive commodity investing, which suffers from negative carry costs; instead, use active trend following to capture volatility spikes while avoiding the cost of holding physical goods during quiet periods.
• Prepare for "higher for longer" interest rates, as inflation is structurally "sticky" and will not dissipate as quickly as it arrived.
• Look for opportunities in the "Green Transition" (e.g., lithium, copper), as this sector creates massive supply/demand imbalances that generate strong trends for traders.
• Avoid timing your strategy allocation based on recent performance (recency bias); allocate based on the structural role the asset plays (e.g., protection) rather than chasing last year's returns.