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Expectations for Inflation

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This guide takes a look at three FlexShares funds built to help investors achieve their financial goals in the midst of potential inflation.

A scenario can be defined as a specific possibility. When people are wondering what to do, they think of different scenarios. Scenario planning is a strategic planning method that some investors and organizations use to make flexible long-term plans. After the financial crisis in 2008, investors worried about their investments and global deflation became a major investment theme for investors. In the wake of the U.S. Presidential election, many investors are now anticipating higher levels of economic growth with a corresponding growth in inflation.

Breakeven Inflation Expectations-Historical Comparison Jan 2, 2017 – Jan 24, 2018

The breakeven inflation rate represents a measure of expected inflation derived from 10-Year Treasury Constant Maturity Securities and 10-Year Treasury Inflation-Indexed Constant Maturity Securities. The latest value implies what market participants expect inflation to be in the next 10 years, on average. Source: Federal Reserve Bank of St. Louis, January 31, 2018.

STOKING INFLATION FIRES

Against a backdrop of U.S. tax reform, the declining U.S. dollar and higher commodity prices, TIPS breakeven spreads (BES) have been on the rise since mid-December, reversing the trend seen through most of 2017.1 BES measure the difference in yield between similar maturity Treasury yields and the current yields on comparable TIPS.

Rising BES is one indicator that investors have historically used to measure expectations for higher inflation. One-year BES reached 2017 highs during the first quarter before falling in the aftermath of failed health-care reform by Congress.2 Though expectations for inflation were dwindling in 2017, actual inflation came in above expectations.3 TIPS modestly outperformed Treasury securities through 2017, meaning that many TIPS investors did not sacrifice total return performance to maintain inflation protection.4 As investors continue to expect higher inflation, reflected by BES, those who think inflation will trend even higher may benefit from holding a position in TIPS.

We believe that there are two drivers of inflation — demand-driven and supply-driven inflation. Many economists believe that demand-driven inflation can be labeled as “good inflation” because often times it reflects overall economic growth, such as an increase in average hourly earnings, and stimulates the supply of goods and services. Supply-driven inflation can be labeled as “bad inflation” because it may reflect non-economic drivers, such as the price of oil, which can have a negative impact on both the supply chain and labor markets and tends to cut demand.

Whether you believe that inflation is a potential future threat to your investment portfolios will depend on many factors. We offer three investment solutions that may help investors as they decide what is right for them. This guide takes a look at three FlexShares funds built to help investors achieve their financial goals in the midst of potential inflation.

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TIPS: Linking to Inflation

The introduction in 1997 of Treasury inflation-protected securities (TIPS) in the United States offered investors multiple potential benefits. First, the development was intended to offer investors a security that would enable them to hedge inflation. Second, by taking on the risk of inflation, the U.S. Treasury Department would not have to pay an inflation risk premium on its securities, thereby lowering its expected borrowing costs. Finally, the securities would provide a market-based measure of inflation expectations. It would be possible to gauge market expectations of inflation by comparing the yields on nominal Treasury securities with yields on inflation-protected securities of comparable maturities.

Benchmark TIPS Rates -
 Historical Comparison Jan 2, 2017 - Jan 24, 2018

Treasury inflation protected securities (TIPS) refer to a treasury security that is indexed to inflation in order to protect investors from the negative effects of inflation. Source: Federal Reserve Bank of St. Louis, January 31, 2018.

For some investors, however, that protection has come with an unanticipated expense — the added time, effort, and fees incurred by investors attempting to target the “duration” of their investments to match the risk exposure of their portfolio. But first, what is “duration”? Duration is how sensitive your investment is to a change in interest rates. You will often see it expressed as a number of years – the higher the number the more volatile will be the expected change. Historically, rising interest rates have often meant falling bond prices, while declining interest rates have meant rising bond prices. So the ability to target a specific duration based on your exposure is key to successfully protecting yourself against the threat of inflation. FlexShares® iBoxx®® Target Duration TIPS Index Funds targets Modified Adjusted Duration (MAD) which takes into account the inflation component of TIPS securities.

Potential Portfolio Benefits – TDTT & TDTF

  • Inflation hedging benefits of TIPS
  • Duration management with effective interest rate risk management
  • Purchasing power protection

GUNR: Moving Upstream

With growing populations and increasing per-capita income, global markets are in the early stages of what is expected to be an extended period of demand expansion for energy, food products, metals and other natural resources such as paper and water. These are the building blocks of flourishing economies.

FlexShares Morningstar® Global Upstream Natural Resources Index Fund (GUNR) is designed to give investors a focused and convenient way to participate in this potential rising global demand for natural resources. Unlike some funds, we do this by focusing on the upstream segment of the resource supply chain. The upstream segment refers to the beginning of the supply chain, when resources are extracted from the ground and sold to producers. By adding focused exposure to the upstream market, we believe investors can minimize the risk of rising resource prices to their downstream investments.

Price of Crude Oil - West Texas Intermediate, Jan 2009 - Jan 2018

West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing. Source: Bloomberg, January 31, 2018.

This fund is built by focusing on global companies in the key upstream sectors — energy, metals and agriculture — balanced with core investments in the timber and water industries. By taking a diversified approach, the Fund seeks to prevent overexposure to any one area in the natural resources field. As global prosperity and demand for natural resources rise, we think our upstream index fund provides a great way to build your exposure to the growth potential of the natural resources market.

Potential Portfolio Benefits – GUNR

  • Inflation hedging benefits of natural resources
  • Continually rebalanced using a rules-based methodology
  • Focus on global companies in five upstream sectors

NFRA: Mission-Critical Projects

After decades of neglect, the need to ramp up spending on infrastructure is coming to the forefront as economic growth is being realized globally. Increasingly, institutional investors, sovereign wealth funds and others have been allocating assets to infrastructure.

The term infrastructure refers to fundamental facilities and systems that serve a city, an area, or a country. Infrastructure assets are mission-critical capital projects that move people, energy, goods and data and earn fees for their use through contracts and concessions. Some examples of traditional infrastructure projects are bridges, tunnels and toll roads; airports; pipelines; and electric, gas or water and sewage utilities.

Infrastructure equities have historically demonstrated a favorable income return pattern when compared to other equities. As the chart shows, global infrastructure had an annualized dividend yield of 4.29% from 12/30/2008 to 12/29/2017, out yielding U.S. large cap stocks, which had a yield of 2.15% over the same time frame. Dividend yield is the dividend expressed as a percentage of the current share price.

Infrastructure as a Source of Income Historical Dividend Yield Comparison Dec 2008 – Dec 2018

U.S Large Cap Stocks: S&P 500 index. Global Infrastructure: S&P Global Infrastructure Index. Past performance is not indicative of future results. One cannot invest directly in an index. For illustrative purposes only not representative of an actual investment. Source: Bloomberg, December 30, 2018.

We believe infrastructure presents a long-term inflation hedge as the revenues infrastructure projects derive are heavily regulated and often tied to the Consumer Price Index (CPI). Investors interested in ways to diversify and hedge portfolios may want to consider the FlexShares STOXX® Global Broad Infrastructure Index Fund (NFRA) as both a real asset and as an equity holding.

Potential Portfolio Benefits – NFRA

  • "Bottoms up" universe definition for improved category depth
  • Greater breadth with a focus on sub-sector representation
  • Wide spectrum of infrastructure asset classes including communications and government outsourcing

1 Bloomberg. In this analysis we are making a comparison between the differences between the 1-Year TIPS rates and the 1-Year nominal Treasury rates, the differences between the 5-Year TIPS rates and the 5-Year nominal Treasury rates and the differences between the 10-Year TIPS rates and the 10-Year nominal Treasury rates in order to construct a U.S. Breakeven 1-Year rate, U.S. Breakeven 5-Year rate and the U.S. Breakeven 10 Year rate using data available as of 1/11/2018.
2 Ibid.
3 Bloomberg. Consumer Price Index Urban Consumers YOY Index as of 11/30/2017.
4 Bloomberg. Comparison of the Bloomberg Barclays US Treasury Total Return Index and Bloomberg Barclays US Treasury Inflation Notes Total Return Index of 12/29/2017.


Important Information

FlexShares iBoxx® 3-Year Target Duration TIPS Fund (TDTT) and the FlexShares iBoxx® 5-Year Target Duration TIPS Index Fund (TDTF) may invest in derivative instruments. Changes in the value of the derivative may not correlate with the underlying asset, rate or index and the Funds could lose more than the principal amount invested. The Funds are subject to fluctuation of yield risk, income risk, inflation protected security risk and interest rate/maturity risk. The Funds are non-diversified meaning the Funds’ performance may depend on the performance of a small number of issuers because the Funds may invest a large percentage of its assets in securities issued by or representing a small number of issuers.

FlexShares Morningstar® Global Upstream Natural Resources Index Fund (GUNR) is subject to the global natural resource industry. As the demand for or prices of natural resources increase, the Fund’s equity investment generally would be expected to also increase. Conversely, declines in demand for or prices of natural resources generally would be expected to cause declines in value of such equity securities. Such declines may occur quickly and without warning and may negatively impact your investment in the Fund.

FlexShares STOXX® Global Broad Infrastructure Index Fund (NFRA) is subject to infrastructure-related companies risk and MLP risk. Risks associated with infrastructure-related companies include: realized revenue volume may be significantly lower than projected and/or there will be costs overruns; infrastructure project sponsors will alter their terms making a project no longer economical; macroeconomic factors such as low gross domestic product (“GDP”) growth or high nominal interest rates will raise the average cost of infrastructure funding; government regulation may affect rates charged to infrastructure customers; government budgetary constraints will impact infrastructure projects; and special tariffs will be imposed.

The iBoxx® 3-Year Target Duration TIPS Index and the iBoxx® 5-Year Target Duration TIPS Index are the intellectual property (including registered trademarks) of Markit iBoxx® and/or its licensors (“Licensors”), which is used under license. The securities based on the Index are in no way sponsored, endorsed, sold or promoted by Markit iBoxx® and its Licensors and neither of the Licensors shall have any liability with respect thereto.

The Morningstar® Global Upstream Natural Resources Index is the intellectual property (including registered trademarks) of Morningstar® and/or its licensors (“Licensors”), which is used under license. The securities based on the Index are in no way sponsored, endorsed, sold or promoted by Morningstar® and its Licensors and neither of the Licensors shall have any liability with respect thereto. The STOXX® Global Infrastructure Index is the intellectual property (including registered trademarks) of STOXX® Limited, Zurich, Switzerland and/or its licensors (“Licensors”), which is used under license. The securities based on the Index are in no way sponsored, endorsed, sold or promoted by STOXX® and its Licensors and neither of the Licensors shall have any liability with respect thereto.