Is inflation upon us?
Since early February, the yield on the 10-Year Treasury jumped from less than 1% to over 1.5% on Friday—a big surge in a short time frame. Alongside this increase, inflation expectations now top 2.5%, the highest level since BEFORE the Great Financial Crisis of 2008 over 12 years ago.
The Federal Reserve Bank is saying it is not yet alarmed by this development, but many investors are nervous that on-going stimulus, combined with signs the economy is ramping better than expected, mean rates and inflation might continue to surge. Surging rates could threaten both the recovery and risk assets, as well as bond prices.
In this note, we provide our outlook and what the prospect of rising rates might mean for your wealth picture.
- The pandemic amplified existing market imbalances to extreme levels. In the post-pandemic world, investors need a new playbook.
- A surge in rates and inflation is typically bad for investors in stocks and bonds. At this point, however, we think a sustained surge is unlikely. We see enough slack in the economy and enough pent-up demand to keep inflationary forces in check for now.
- We are already seeing implications of the new playbook, which includes a moderate increase in rates. Markets are behaving as you would broadly expect.
- We believe positioning remains key: favoring smaller stocks, valuation-sensitive stocks with good quality fundamentals, diversified portfolios, and bond maturities with only moderate duration. Inflation-hedges within portfolios also play an important role.
We believe market activity over the past three years hit an unsustainable extreme, driven by near-zero interest rates, anemic economic growth, and aggressive monetary policy. These conditions rewarded a narrow set of investment winners and worked against diversified, balanced portfolios. The pandemic did not create those extremes; it only served to accelerate and amplify them.
As we enter the post-pandemic period, we continue to believe a new economic regime is emerging, presenting different risks and opportunities for investors. With greater fiscal stimulus, rollout of vaccines, and high savings levels, economies are beginning to re-open. We are already seeing the signs of change in the markets.
In that vein, we would expect to see moderate increases in rates. Rising rates, within reasonable bounds, are a natural indication of recovery toward a healthier economy. Importantly, the broader yield curve—which provides a picture of short- and long-term rates relative to each other—has steepened favorably in the past six months, illustrating investor willingness to take more risk over time. All that makes sense in re-opening.
The question is, what are reasonable bounds for rates? We would expect a gradual path to yields and inflation of say 2.5% and 3.5%, respectively, would be very manageable for equity investors. A sudden spike to those levels, however, would be cause for concern, in our view.
We think the risks to inflation are balanced for 2021 and heading into 2022 at this point, for two key reasons:
- There is still considerable slack in the economy. Unemployment has (thankfully!) improved (now 6.2% from a peak of almost 15% last April), but our economy is still an estimated 9.5 million jobs shy of where it was pre-pandemic. That condition should limit inflationary pressures for now, particularly in the beleaguered services economy.
- We see pent-up demand after forced lock-downs. February’s jobs report last week offered further evidence: restaurants and hospitality increased hiring as re-opening occurs. Plus, household saving is near historic highs, providing ready cash for spending as the economy re-opens.
To sum up, we continue to expect a solid recovery in the second half of this year, with room to run as the services economy opens up. Some sectors—e.g., manufacturing and home builders—may be near capacity now and show inflationary pressures, but the broader story of a services recovery is still in play. We think yields and inflation may ebb and flow as markets digest the pace of re-opening—perhaps creating some fear and confusion—but we don’t expect sustained excessive levels over the next 12-18 months.
Longer-term issues of government debt levels, deficits, and excess liquidity are important but less influential factors at this point, in our view. We will of course be monitoring developments closely.
Rising rates are clearly a challenge for fixed income and bond-like investments (high dividend-paying stocks or defensive utilities, for example), but equities typically do fine in a rising rate environment, as long as rates don’t spike.
This is a unique period, however: historically low rates, combined with fears of recession from trade wars (2018) and the pandemic (2020), conspired to create extreme, unsustainable positions in last year’s markets. During this time, investors pushed (chased?) prices in High Growth Tech and US Treasury Bonds to unsupportable levels (for clearly different reasons), in our view. For long-term investors, we saw risk to concentrated and imbalanced portfolios. We made strategic steps during this period to position portfolios for long-term opportunity, as we described throughout 2020.
Thus far in recovery, our actions have served us well as we emerge from the pandemic, and markets are behaving as we would broadly expect (see Exhibit):
- Re-opening favored small stocks and more diversified portfolios (as measured by the S&P 500 equally weighted index). “Value” stocks also began to lead.
- We have seen signs of excess, where investors speculate beyond what we believe fundamentals would support (options trading, SPACs, unprofitable companies, etc.)
- Concern over rising rates since early February has encouraged investors to sell High Growth stocks (particularly Tech) and other rate-sensitive sectors like utilities and home builders.
As long as rates rise in a reasonable fashion and the economy continues to re-open, we believe this positioning should continue to be appropriate.
Exhibit: Comparative Returns of Major Indices
Inflation can be a challenge to wealth generation because it can increase the cost of living and reduce the spending power of money. In the US, for much of the past 30 years, inflation has been relatively benign—except in some areas like higher education and health care—exceeding 3% or 4% only occasionally. Frankly, risk of deflation has been the bigger challenge for the past ten years.
We strive to manage inflation risk by 1) building portfolios that generate returns that exceed inflation and 2) active efforts by investors to manage their regular spending levels.
- Assets that tend to benefit from inflation include commodities, REITs, emerging market equities and debt (particularly for countries exporting commodities), and TIPS. We use elements of these allocations as part of a diversified portfolio, as appropriate for a client’s risk tolerance and investment horizon. Over short periods, these allocations can increase portfolio volatility.
- Spending rate is one of the few areas that investors can directly control. For investors looking for their investments to exist in perpetuity, that spending rate should be around 4% in most cases… and lower is better if investment growth is the goal.
Historically, inflation of over 3% exists about half the time, but the trend (whether it’s rising or falling) is equally important.
- While rising inflation tends to be bad for bonds, equities can do well when inflation is low-to-moderate and increasing at a steady rate.
- We would become concerned with broader equities if inflation were to see a sustained spike above 4%.
We continue to believe investors are entering a new era, with different risks and opportunities for long-term investors compared to the past three years. Low rates, anemic economic growth, and aggressive monetary policy created a limited set of temporary investment winners. As economies re-open, vaccines materialize, and fiscal policies emerge, we expect a new set of economic drivers to take over. Chasing last year’s limited winners is not the answer, in our view.
We believe market activity since last summer is indicating what the new period might look like, and what investment strategies are better suited. Rising rates within reason should be expected as economies reopen, with government intervention—particularly through fiscal policies—continuing to play a supportive, active role.
As we move into recovery (2021), the curve is at its steepest point in over three years. Compare that to the more risk-averse period (and flatter yield curve) of the past three years as investors navigated trade wars (2018) and the pandemic (2020).
Under current monthly recovery rates, it would take years to reach pre-pandemic employment levels.
This condition required strategic repositioning for better long-term opportunity. Our research led us to favor:
- small stocks over large
- the value and quality styles vs. high growth
- investment grade fixed income with only short- or medium-term maturities; note: we can increase duration in a favorable manner as rates rise
- inflation protection through specialized government bonds (TIPS), where appropriate, as well as our standard allocation to commodities-driven businesses (oil & gas, agriculture, and precious metals)