Investors seem to be compiling a laundry list of inflation concerns lately. The Consumer Price Index (CPI), at 4.2% year over year, is at its highest level since 2009. Supply chain issues are affecting semiconductor and lumber markets. A cyberattack on Colonial Pipeline sent gas prices soaring. Prices for commodities such as copper, iron and even corn are near all-time highs.
But haven’t we been here before? In 2018, the overhaul of the U.S. income tax code with the passage of the Tax Cuts and Jobs Act (TCJA) gave the economy a short-term boost by increasing consumer spending. Simultaneously, oil prices peaked near $80 per barrel and CPI topped out at 2.9% as fears of inflation emerged. Then again in early 2020, just before the pandemic, global manufacturing PMIs were improving, and capital expenditure growth was accelerating. CPI rose to 2.5%. Of course, that all ended when we turned the lights off on the global economy in response to the spread of COVID-19.Now, as the U.S. economy begins to reopen, should investors be wary of rising inflation? Or is inflation a sign of the economy coming back to life?
Inflation: Is It Good or Bad?
There are a few things to consider in terms of which type of inflation markets are facing. “Good” inflation occurs when prices go up as economic growth accelerates. That’s the environment we believe we are in currently as economic restrictions in the United States continue to slowly lift (keeping in mind that about 60% of U.S. GDP by state is still under some form of economic restriction).
“Bad” inflation, on the other hand, occurs when commodity prices rapidly rise to the point where they start to impact earnings growth and profit margins. This would be reminiscent of the late 1970s/early 1980s inflationary period.
So, are there reasons for investors to be concerned? A year ago, with the economy shut down, the United States was in a period of record-low activity levels. Now that reopening has begun and activity levels are on the rise, year-over-year comparatives (comps) are extraordinarily easy, bolstered further by inventories that are still being rebuilt to pre-pandemic levels. This increased activity from record lows lends itself to an environment that feels like prices are rising rapidly. Further, CPI is expected to rise over the next few months until comps get more challenging, and inflation begins to recede.
Chart 1: High Inflation Has Been Difficult to Sustain
Source: Bloomberg L.P., PNC; Data as of 5/11/2021
View accessible version of this chart.
However, even if inflation were to remain higher than 2% for an extended time, we think it would be the “good” type of inflation that would support the global economic recovery narrative.
But market sentiment is interpreting the situation differently. Some are taking the record-high CPI to mean that inflation will run red-hot well into the future, as it did during the “bad” inflationary period of the late 1970s/early 1980s. That sentiment shift seemed to gain momentum in mid-February when the monthly retail sales report came in well above expectations. From there, the Treasury yield curve spread (the difference between the interest rate of the 10-year Treasury and the interest rate of the 2-year Treasury) quickly widened to its highest level since 2015. While a steepening yield curve is expected during the early stages of an economic recovery, it can also be interpreted as a sign of rising inflation expectations.
Bonds are Conflicted
The bond market has been sending mixed signals regarding inflation expectations. Breakeven interest rates, which are inflation-linked bonds that imply future inflation expectations, are at their highest yields since 2013. That in itself would suggest the bond market is issuing a warning for rising inflation. However, that is only part of the story: Nominal interest rates, the typical interest rates quoted in the bond market, are well below breakeven rates.
Chart 2: Bond Market Sending Mixed Signals on Inflation
Source: Bloomberg L.P.; Data as of 5/11/2021
View accessible version of this chart.
The only other time the spread created this environment of negative real yields was the disinflationary euro crisis of 2012. The episode ultimately ended in 2013 during the “taper tantrum” when investors were caught off guard by remarks from then-Federal Reserve (Fed) Chairman Ben Bernanke regarding tapering monetary stimulus.
Interestingly enough, after the April 2021 ISM® Manufacturing PMI® missed consensus estimates and the April payroll report came in well below estimates, real yields declined, moving back to levels from early February — the point in time when inflation sentiment began to shift higher. As it is, nominal interest rates may be off their all-time lows of last summer, but they have not yet recovered to pre-pandemic levels. In our view, that is not a vote of confidence for red-hot inflation as the Fed and other central banks continue to support bond markets with unprecedented levels of stimulus.
As investors, we have to adapt to changing market conditions. Thus, in the event that inflation does stay elevated beyond just the next few months, what asset class exposures would we expect to provide some cover?
As a general rule, we believe that equities, specifically high-quality dividend payers, are the best hedge against inflation.
- Real Estate Investment Trusts (REITs) — Assuming we have “good” inflation and rising interest rates due to an improving global economy, REITs should benefit as interest rates rise and capitalization rates (the rate of return expected on a real estate investment property) improve. It should be noted that here we are referring to more traditional REITs that still make up the majority of the MSCI USA Real Estate Index, not “new age” 5G-levered REITs.
- Emerging Markets (EM) — While many investors rush to increase commodity exposure in an inflationary backdrop via the Materials sector, we actually think adding EM equities exposure makes sense here. While we do not expect the return of a commodity supercycle, EM exposure to commodity-exporting countries (specifically in Latin America) may provide a hedge in the event of short-term inflation.
- Global Infrastructure — Global infrastructure often exhibits greater cash flow stability relative to other sectors. Additionally, the yield pickup is still attractive in a low interest rate environment.
- Leveraged Loans — With a duration of nearly zero and coupon rates that frequently adjust, this asset class is favorably positioned in a rising rate/reflationary environment.
- High Yield — The Bloomberg Barclays US Corporate High Yield Index has a duration that is half that of investment grade credit. If we get the “good” kind of inflation, we believe high yield would stand to benefit as growth improves, especially for some of the more beaten-down areas of the economy and markets.
- EM Debt — With a narrative similar to EM equities, EM debt has the added benefit of income comparable to U.S. high yield.
Perhaps surprisingly, we do not believe Treasury Inflation-Protected Securities (TIPS) provide protection in an inflationary environment. In our view, TIPS do not add value over the Barclays Bloomberg Aggregate Index (Agg) over long time periods. In addition, TIPS are typically long-duration bonds; if interest rates are rising rapidly, TIPS actually do not perform well. For example, in the taper tantrum year of 2013, TIPS not only lagged the Agg on a relative basis, but on an absolute basis the asset class was down nearly 9%. In 2018 when the 10-year Treasury yield peaked at 3.25%, TIPS delivered negative returns while the Agg managed to deliver a positive return.
In conclusion, coming out of the financial crisis in 2009 there was considerable concern around interest rates spiking and inflation getting out of control. None of this actually transpired despite significant monetary and fiscal stimulus in effect at that time. We believe there will be a similar outcome this time around even though the magnitude of stimulus is far greater than it was in 2008-2009. Many of the current issues regarding rising commodity prices are transitory, in our view, caused by supply chain issues instead of evidence of “pent-up demand.” Rather, we believe the effects of structural factors such as demographics, technological innovation, and energy supply/demand dynamics actually act as a lid on rising long-term inflation. In our view, the probability of an inflationary accident remains low and poses little long-term risk to the recovery.
Accessible Version of Charts
|Date||Consumer Price Inflation Y/Y (%)||Current Market Sentiment (%)||Realistic Outcome (%)|
*E = Estimated
|Date||10Y Treasury/10Y Breakeven Spread (%)