Inflation on the Horizon?
Central banks, including the Federal Reserve, have injected massive amounts of liquidity into their respective economies over the last several months to battle the recent meltdown in the credit markets. Despite this rapid growth in the money supply, we believe that in the aftermath of a pending recovery, inflation is more likely to be contained than not. Current high levels of unemployment (US rate at 9.5%), a transition to a climbing personal savings rate (US at 6.9%), low capacity utilization (US at 68.3%) and a still modestly capitalized global banking system are likely to act as a buffer against a rapid and sustained rise in inflation. Still, we acknowledge that future monetary policy mistakes (e.g., failure to remove some liquidity), the continuation of large federal budget deficits (12% of US GDP for fiscal year 2009) and US Dollar depreciation could result in higher inflation rates over the next several years
We are reviewing inflation sensitivities in client portfolios across various investment sectors, as higher inflation levels in the past have had a variety of adverse impacts, including:
- generally higher interest rates
- greater required inflation premiums
- lower operating profit margins; and
- depressed inflation-adjusted profits.
We will look to hedge inflation risks for specific investment sectors if we believe that hedging costs are priced effectively relative to our assessments of possible inflation losses.
Past US Inflation Experience: As evidenced in the graph below detailing changes in the CPI-U1, inflation levels over the past 25 years have been rather muted since the Federal Reserve (under the direction of Paul Volcker in the early 1980’s) broke the back of then persistently high US inflation rates. Over the last 25 years ended May 2009, multi-year annualized CPI-U changes consistently have been in the 2.5% to 3.0% range. Since the early 1980’s, the Federal Reserve has conducted monetary policy effectively in both expansionary and contracting periods in a manner that has avoided a sustained upsurge in inflation or the occurrence of actual deflation (falling prices).
Source: Bureau of Labor Statistics
The modest inflation experience for the US over the last few decades was aided by a global expansion of trade and low import price inflation (1.15% annualized over 20 years) generally placing a lid on domestic prices; the absence of wage push inflation experienced in the 1970’s; a solid increase in output per hour (annualized 2.2% over 20 years ended May 2009) allowing for non-inflationary wage growth; and relatively mild economic cycles.
While the Fed, since the early 1980’s has been very vigilant about containing inflation to the upside and has more recently identified a preferred longer term 2% inflation target, its focus during both the 2001 and the current 2007-2009 downturns has been to avoid deflation. For the period March 2009 to May 2009, year-over-year changes in CPI-U were actually negative, the first such declines since 1955. Decreases in energy prices (down 27% for year ended May 2009) drove CPI changes to negative levels as Core CPI (excluding food and energy) changes have remained centered about an 2% annualized over the last several years
Market, Inflation, and Interest Rate Expectations: With the introduction of Treasury Inflation Protection Securities (TIPS) in 1997, the capital markets have offered a direct means to assess investor consensus expectations as to future inflation rates. TIPS offer both a real coupon payment plus inflation adjustments determined by CPI-U changes. TIPS real interest payments (excluding inflation adjustments) are contrasted against interest rates of conventional US Treasuries to obtain breakeven inflation-adjusted yields. As an example, if the 10-year Treasury yield is 3.50% and the 10-year TIPS real yield is 1.85%, then the break-even inflation adjusted yield (BIY) for the next 10 years would be 1.65%. If CPI-U inflation then were to average above 1.65% over the succeeding 10 years, then the total cumulative return of the 10-year TIPS would be above that of the comparable Treasury note.
The 10-year BIY was relatively stable from 2004 to the 3rd quarter of 2008, when the credit crisis fully erupted. From approximately 250 basis points in mid-2008, the 10-year BIY dropped to a slightly negative level in November 2008 as investor consensus coalesced around a disinflationary forecast against the backdrop of negative real US GDP growth accompanied by a full blown credit crisis. The drop in the 10-year BIY was partially produced by the very strong investor preference for the liquidity and safety of conventional Treasuries that drove 10-year Treasury yields down to the low 2% range toward the end of 2008.
With the worst of the credit crisis apparently in the past, investor inflation expectations have picked up, although the present BIY level of 170 bps in early July, 2009 is still below the average range prevailing before the 2008 credit crisis. As seen in the graph above, the BIY can move substantially upward or downward in a relatively short time period, implying that investor inflation expectations can change very rapidly.
Currently, investors expect that the Fed will reverse course and begin to raise its targeted Fed Funds rate in 2010. The futures markets indicate that the Fed Funds rate will rise to 2% by February 2011 from the current level of 0.25%. We, likewise, expect the Fed to reverse its current easing policy stance and to remove excess liquidity from the markets, but slowly. This reversal process is likely to take several quarters as it appears that the global economic recovery, while positive, may not be especially strong over the next few years.
With a rise in shorter-term rates, longer-term investment-grade yields are likely to climb from currently low absolute levels over the next 2 to 3 years. The 10-year swap rate2, which was 3.70% as of early July, is projected through forward curve analysis to rise to 4.65% in 3 years. Under such circumstances of moderately rising yields, intermediate-term fixed income portfolios could suffer moderate price declines of 5% to 7%. We expect that credit spreads could diminish along with recovering US and global economies, implying that yield increases for non-Treasury sectors will not move upward to the same extent as possible Treasury yield increases.
Because higher inflation rates normally translate directly into higher interest rates and associated negative price changes for fixed income investments, it is more straightforward to anticipate the impact of inflation on fixed income investments than it is for equities. Still, while linked, interest rates and inflation are subject to different forces and a straightforward connection cannot be predicted. We’ll explore this complex relationship further in future Insight articles.
For equities, with inflation largely contained over the last 25+ years, changing investor inflation expectations and any related price effects on equities need to be viewed against a backdrop of generally rising profit margins, broader revenue diversification for companies outside the US, and the price support for the public equity markets from higher levels of private equity transactions.
When inflation surprised to the upside in the 1970’s, not only did equity prices remain mostly static but price/earnings (P/E) ratios dropped to the 7X range over several extended time periods as profit margins were impacted negatively due to substantial cost increases, including wages, that outpaced lagged revenue increases. This reduced range for P/E ratios is evidenced by the graph above where the S&P 500 Index P/E ratio did not consistently exceed 10X from 1973 to 1984. Unlike the generally positive US economic performance from the early 1980’s to 2007, the 1970’s were defined by the frequency and severity of economic cycles (recessions in 1970, 1973-1975 and 1980). Equity price performance in the 1970’s was influenced by factors specific to that time period: two oil embargoes; expansive monetary policy; wage-induced inflation; and substantial US Dollar depreciation. The P/E ratio for the S&P 500 Index was estimated to be 14.2X in early July 2009 versus a historical average about 15X. For equity prices to rise from current levels, inflation rates will likely have to remain at moderate levels (i.e., 3% to 4% range). We think they will.
Hedging Inflation Sensitivities in Client Portfolios: For fixed income allocations, we are evaluating reducing the negative price effects from unexpected increases in inflation rates through the following means:
- Hedging against an inflation-induced increase in interest rates using structured securities or inflation-sensitive derivatives;
- Increasing participation in an economic recovery (which might stoke inflation) through a moderate increase in credit risk;
- Adding non-US fixed income with unhedged currency exposures to take advantage of possible US Dollar depreciation.
In the broader portfolio, we expect inflation protection from:
- Non-US equity markets with unhedged currency exposure and, especially, commodity-exporting emerging markets;
- Real estate; and
- Direct investments in commodities.
Our Investment Committee will continue to monitor US and global economic developments to ascertain trends in inflation developments with a focus on the possibility of significant changes in inflation levels. To the extent possible, we will adjust overall portfolio allocations and use inflation hedges within specific sectors to offset potentially adverse price changes resulting from higher-than-expected inflation rates.
Carl Forster and Rich Palmer
1Consumer Price Index- All Urban Wage Earners. The CPI-U represents a price index for a standard basket of goods and services purchased for consumption by urban households. Core CPI-U is calculated from the base CPI-U Index after removing food and energy price components, which display more price volatility.
2Swap yields are representative of interest rate contracts among financial institutions and reflect the generally high credit ratings of the counter-parties (i.e., commercial banks and brokers).