On January 30, 2017
AAM Viewpoints - Inflation is Staging a Comeback
Noticeably absent from what has become the longest bull rally in the history of U.S. markets, inflation looks to be staging a comeback. For fixed income investors with the prospects of higher inflation come the prospects for higher interest rates and structuring portfolios and allocations to insulate and take advantage of higher inflation becomes paramount. While many view inflation as a specter to be avoided at all cost, a modest amount of inflation is actually important in supporting a healthy, growing economy. Price stability – i.e. a healthy level of inflation – is one of the dual mandates of the Federal Reserve with the other being labor market stability. The Fed seeks to foster price stability through policies that they feel will help to generate an expectation of future inflation. Inflation expectations are the key as to why a modest level of actual inflation is important for an expanding economy. Expectations for higher prices in the future tend to lead to current consumption of goods and services, whereas expectations for lower prices in the future tend to lead to consumers deferring consumption in anticipation of lower prices. Especially as it relates to the U.S. economy, in which the consumer makes up almost 70% of GDP, one can see why inflation expectations as well as the actual level of inflation are an important focus for the Federal Reserve. In fact, efforts to create inflationary pressures were one of the main drivers of the extremely accommodative policy stance and quantitative easing efforts we have seen post credit crisis. In spite of these efforts inflation has remained doggedly low with the Federal Reserve’s preferred measure of inflation, PCE (Personal Consumption Expenditures), touching the 2% level only once post-2008. With that said, improvement in the economic landscape, both here in the United States and globally over the last 6-12 months, along with the U.S. election, which brought with it prospects for fiscal stimulus, could portend higher inflation is in store.
While U.S. equity markets performed admirably in 2016, from an expansionary standpoint, we stumbled a bit as U.S. GDP growth for the year slowed to 1.6% (U.S. Real GDP 2016) – the lowest level since 2011. This was due, in no small part, to a rough start to the year with the United States posting sub-1% GDP in Q1 (1st quarter) 2016. Along with weak GDP, U.S. credit markets were in turmoil to begin the year with significant credit spread widening reflecting concerns over weakness in commodity and energy markets. Bearish sentiment seemed to reign supreme in both U.S. equity and fixed income markets and the balance of the global economy was not faring much better as growth prospects waned around the world. The same weakness in basic materials and energy that created volatility in U.S. credit markets was creating deflationary pressures and dragging down growth on the global stage in both developed and emerging markets. These events culminated mid-year 2016 to leave the U.S. 10-Year Treasury at an all-time low of 1.36% (07/08/2016) and brought an inflection point with significant improvement in the global landscape in store for the balance of 2016. Manufacturing and industrial activity around the world began to improve throughout the balance of the year, U.S. GDP growth strengthened versus a weak first half, corporate earnings began to show improvement, commodity prices firmed and labor market strength in the United States all contributed to expectations for higher inflation on the horizon. The U.S. election then brought the potential for a round of fairly significant fiscal stimulus likely accelerating the inflationary trend already in place by early November. Pro-growth policies such as lower taxes, for both individuals and corporations, less regulation and more government spending all tend to be inflationary in nature as is a more protectionist tilt in regards to global trade. Prospects for fiscal stimulus in the United States, improving economic metrics in developed and emerging markets as well as heathy conditions in the Unites States all helped lead to a reversal of the deflationary trend in place to begin the year. The path of expected inflation over the course of 2016 illustrates the strong shift in inflation expectations that began in earnest mid-year accelerating with the U.S. elections in November.
As mentioned earlier, inflation expectations – a leading indicator – play a key role in driving actual inflation as measured by lagging inflation indicators such as the CPI (Consumer Price Index). The 10-Year Breakeven Inflation Rate is a gauge of the markets expectations on the future rate of inflation over the next ten years. After touching a post credit crisis low of 1.20% in early February, inflation expectations moved up to 2% by year end with an inflection point mid-year and an acceleration of the trend in November with the U.S. presidential election. These inflation expectations were confirmed by year end as Headline CPI converged with Core CPI (ex. food and energy) as energy weakness abated with Headline CPI touching the 2% level for the first time since 2014.
CRN: 2017-0117-5743 R
With the prospects for higher inflation in 2017, we see the need to ensure fixed income portfolios are structured and allocated in an inflation resistant manner. While few bonds are immune to higher inflation and higher interest rates, you can help reduce a portfolio’s sensitivity to higher inflation and in some cases position assets to take advantage of an increase in the prevailing level of inflation. To begin, we would structure portfolios with an eye toward defensively-positioned duration. Duration is technically a measure of interest rate sensitivity but is closely tied to the concept of inflation as higher inflation tends to generate higher interest rates. We would position portfolios with a duration of approximately 75%-85% of the applicable benchmark duration. In addition to a defensive duration we would look to generate above-market cash flows in the form of higher-than-market coupon rates. Inflation erodes purchasing power and reduces the value of fixed cash flows. In an inflationary environment, the quicker one can reinvest the more one can offset the reduction in purchasing power associated with higher levels of inflation. Investing in fixed income with large coupons can assist in this aim. A tilt toward credit risk and lower quality bonds in lieu of higher grade, more rate-sensitive fixed income typically helps performance in inflationary environments. Lower quality bonds tend to be more sensitive to improving economic growth which is typically present as inflation increases. We would also look to assets that tend to be sensitive to inflation including TIPS (Treasury Inflation Protected Securities), floating rate fixed income and fixed income tied to inflation indices such as CPI floaters. Finally, we would consider sector exposure to areas that historically benefit from higher inflation such as basic materials, commodities and financials. With an eye toward portfolio structure, asset allocations and sector exposures one can position to help insulate against and in some cases take advantage of higher levels of inflation. As always, risk tolerance and investor suitability should dictate investment decisions.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.