INSIGHTS

On April 25, 2022

AAM Viewpoints — Regime Change: Inflation and the End of the Great Bond Bull Market

White Heat (noun) – Merriam Webster

1. a temperature above 1,500 degrees
2. a state of intense mental or physical strain, emotion or activity

Thus far, 2022 has more than delivered on our expectations for a challenging year. A year we expected would bear witness to the beginning of a “Secular Regime Change” driven by three key themes:

1. Inflation that remains hotter and higher and lingers for longer than the market, and certainly the Fed had expected.
2. Driving interest rates up and forcing the Fed’s hand to move further and faster.
3. Ending a 40-year bull market in rates and causing a central bank policy pivot creating uncertainty and heightening market volatility against slowing economic growth.

What we had not factored in was Russia's war on Ukraine which only served to aggravate each of the three themes above. While not quite 1,500 degrees, inflation has yet to peak and at 8.5% it is white hot. Hot inflation ignited Merriam’s second definition; causing the Fed and investors a state of intense mental and emotional strain with significant “activity” by way of corrections in the equity markets and the worst start to the bond market in generations. It was a particularly savage start for traditional fixed income which, as of this writing, is holding on to a negative return of more than 9%, a figure more akin to an equity market drawdown and twice as severe as 2013’s infamous “Taper Tantrum.”

It is no surprise that uncertain and volatile markets such as these are often paired with investor inaction as we await a clearer trend or for the correction to “correct.” However, given the structural nature of this market catalyst (lingering inflation paired with higher rates and a hawkish central bank that is way behind the curve) we think waiting and expecting the correction to “correct” will result in sub-optimal portfolio outcomes. What has worked in the past — in an era of ever lower rates and an ever increasing Monetary and Fiscally spiked punch bowl — will not work today nor for portfolios looking in the rearview mirror and applying yesterday’s asset allocation playbook. 

We believe it is time to employ a new investment playbook that favors assets that benefit from and dampen volatility against inflation and higher rates. And although it may be tempting to extend duration to capture higher yields, it seems likely rates will continue to head higher as the Fed begins to shrink its massive balance sheet by $1 trillion per year or more. At the same time, the economy is slowing as mortgage rates climb and the “inflation tax” draws dollars away from discretionary consumer spending. This confluence creates a high degree of difficulty of the dive the Fed is trying to achieve in sticking a soft economic landing. We would argue the shifting landscape requires shifting portfolio allocations now, while the opportunity currently exists, to prepare for the regime change currently evolving. 

Asset Allocation Framework Considerations

In our asset allocation framework, we suggest:

• Underweighting longer duration assets in both fixed income and equities. We have already begun to see a rotation away from longer duration equity sectors, such as technology, and see significant outperformance in companies with steady cashflow and income from dividends which tends to shorten the duration risk (i.e. sensitivity to interest rates). We expect this trend to continue and consider the leadership change to be durable and in sync with a higher rate and inflationary environment.
• Maintaining a continued overweight to equities vs fixed income.
• Within fixed income, we favor credit over duration in areas such as senior secured bank loans where rates reset as interest rates rise. Intermediate municipals are also offering tax adjusted yields at very favorable levels with ratios approaching 90% to taxables. We also favor alternative income generators like select REITs (Real Estate Investment Trusts), BDCs (Business Development Companies) and MLPs (Master Limited Partnerships).
  
• In equities, we favor value over growth (value sectors tend to have more steady cash flow streams) and dividend raisers over cutters. Steady dividends will become an important component of return as P/E (price to earnings) multiples face the head wind of higher rates.
• We also suggest adding allocations to commodities, materials, mining and energy sectors, which we believe are still early in their secular rebound despite recent outperformance, have more room to grow, and are sectors that typically do well in inflationary environments.

Inflation – A “Sticky Wicket”

As for inflation, we do expect it to come down due to year-over-year base effects. However, inflation is embedding into expectations and structural changes in the economy are aggravating how long it may take for inflation to reach (if at all) the Fed’s 2% target, which likely will take years.

First, wages are rising close to 5% per year. There is a mismatch between labor supply and labor demand. A slowing economy may help balance that a bit however, inflation and the negotiating leverage the labor force has today will likely result in elevated inflation for wages for the foreseeable future. Shelter costs are also elevating. There has been chronic underbuilding of housing that has occurred for over a decade post the 2008 housing bust. At the same time, institutional investors are a new source of demand as the rise of the “single family rental market” continues to add new buyers into competition for limited inventory. A recent study by the digital real estate company Redfin found that 18.4% of homes purchased in the 4th quarter of 2021 were bought by institutional investors. Even if home buying slows down because of higher rates, what is the alternative? Renting. Here the story is also not very encouraging. Rental stock is also in short supply and rental rates are climbing fast. Add in the energy, materials and commodity shock from the Ukraine war and recent Chinese lock downs and we see inflation is broadening across the board.

Inflation – Shelter Costs

Broader Secular Inflationary Shifts

As for the war, that tragic event only served to further expose and highlight the secular nature of the shift we foresee. Inflation, or rather disinflation, had been a beneficial consequence of globalization and sourcing supplies in the most cost-efficient manner possible. Inventory management could be delivered “just in time” and from the lowest cost producer throughout the world in what the economic textbooks call “comparative advantage.” Food, energy, commodities, and goods all flow in ways that focus on cost efficiency. The pandemic, and now the Ukraine war, have exposed the risks and consequences of this system. As a result, we are seeing a new textbook chapter being written on globalization which is focused not only on cost management, but also on risk management. Onshoring, “just in case” vs “just in time” inventory and supply chain management, energy, material, and food supply sourcing are all being given a rethink. While no one knows how much this will shift the inflation equation, clearly the trend will be higher.

Economic Slowdown Coming

The outcome of inflation and rising rates is beginning to take its toll on consumer spending, which is two-thirds of GDP (Gross Domestic Product). Inflation acts as a regressive tax and while nominal retail sales figures are still high, after inflation spending is softening.

Mortgage and Inflation Tax Impact on Consumer

Source: Strategas Research

We see economic growth slowing and to us, real U.S. GDP seems poised to fall below the consensus estimates of 3%. We also note that last week the IMF (International Monetary Fund) meaningfully reduced its global real 2022 GDP growth forecast from 4.4% to 3.6%.

Positioning for What May Be Ahead

Despite these challenges, we believe there are good opportunities to position asset allocation strategies to take advantage of these trends. We suggest repositioning portfolios now for what lies ahead. We expect higher cashflow generating assets such as REITs, BDCs, and MLPs to perform well and floating rate bonds, such as bank loans, will benefit as rates rise. We expect the dispersion we have seen thus far this year by sectors will continue as the Fed-induced, high liquidity tide continues to ebb. We see meaningful positive alpha differentiation by favoring value over growth and as well, for dividend growers vs dividend cutters/non dividend payers. We expect this to be a long-range trend as dividends become a larger share of total return and help blunt the sensitivity of “equity duration” and rising rates.

Inflation, Rates, and Volatility Driving Dispersion

As for the Fed, recent comments from Chair Powell, Governors Bullard and “dove” Brainard, among others, indicate their distress in realizing they are, as Mr. Bullard said this week: “…way behind the curve.” That distress recalls again, Merriam’s second definition of white heat. As the Fed tries to cool white hot inflation and stick the soft landing, a well-prepared portfolio will likely deliver a better outcome than relying on yesterday’s asset allocation playbook.