By Kathy Jones and Christina Shaffer, Charles Schwab
Economic growth is picking up as the vaccine rollout gains speed, commodity prices are heading higher, the government is proposing another large fiscal aid package, and the Federal Reserve is pledging to keep its very easy monetary policy intact for the foreseeable future.
Not surprisingly, inflation expectations are rising. Given these factors, how concerned should bond investors be about inflation? Here’s our take on the current situation, and what investors can consider doing now.
There are many ways to measure inflation. The most widely used measure is the Consumer Price Index (CPI). It captures price changes for a broad basket of goods and services. It’s the measure used for cost-of-living adjustments in many employment contracts and for Social Security payments.
The benchmark measure used by the Federal Reserve is the deflator for personal consumption expenditures, or PCE. While policymakers follow a range of indicators, the PCE excluding the volatile food and energy components (core PCE) is the one most often referenced by the Fed.
Currently, the inflation picture looks tame, with most indicators remaining below the Federal Reserve’s 2% target, despite the differences in their compositions and the methodologies used to calculate them. In fact, inflation has averaged less than 2% since the end of the financial crisis in 2009 and the core PCE has barely budged above 2% for more than a few months at a time.
Inflation is most easily defined as a broad-based rise in prices. One-off price increases, such as a jump in oil prices, aren’t always enough to generate a sustained inflationary trend. While consumers spending a large proportion of their budgets on higher education or health care may experience higher inflation than other consumers, these inflation indicators attempt to capture broad average price changes across the economy.
Generating inflation usually requires demand outstripping supply in the economy, or “too much money chasing too few goods.” When the demand for goods and services is greater than the economy’s capacity to provide them, prices will rise. This relationship is often depicted as the “output gap,” or the difference between the country’s actual growth rate and its potential growth rate.
The Federal Reserve may use it to assess the need for tighter or easier monetary policy. (It should be noted that “potential GDP” is an estimate based on many factors, including productivity and the growth rate in the labor force.)
In the years following the financial crisis, the GDP growth rate was well below its potential and inflation remained tame. When the gap closed in 2015, the Fed began raising short-term interest rates in anticipation of higher inflation. However, inflation remained tame.
With the onset of the pandemic early last year, GDP growth fell steeply, causing the gap to open up again. In response, the Fed cut short-term interest rates to near zero. With ample fiscal and monetary stimulus, the size of the gap has shrunk, but it is still far from closing.
There is still a lot of excess productive capacity as many businesses await stronger demand. Moreover, there is a large excess supply of labor in industries hit by the pandemic. There are close to 10 million fewer jobs now than at the beginning of 2020.
Consequently, the Fed is indicating it won’t raise interest rates until it sees lower unemployment. It is taking a “wait-and-see” approach to raising interest rates, rather than moving pre-emptively against inflation.
The preconditions for rate hikes are low unemployment near or below 4% and higher inflation. Most importantly, the Fed is signaling that it is willing to allow inflation to overshoot its target for a “period of time” to allow the unemployment rate to fall further. Having overestimated the inflation threat for more than a decade, the Fed is inclined to wait for it to show up before acting.
Short- and medium-term prospects
We expect to see an uptick in inflation over the next few months, but it’s likely to be fleeting. Most of the increase we are looking for is due to comparing today’s prices to last year’s steep drop in the spring. On a year-over-year basis, inflation will likely tick higher.
However, getting inflation to hold sustainably above the Fed’s 2% target for core PCE likely will take another year or two, considering the large output gap.
However, when we look a few years down the road, the case for a move up in inflation grows stronger. The Fed’s easy monetary policy stance — when combined with the prospect for another round of fiscal relief of about $1 trillion igniting stronger demand, and a rebound in the economy as the vaccine rollout proceeds — could lay the groundwork for higher average inflation than we’ve experienced for the past decade.
To be clear, we aren’t anticipating a return to 1970s-style inflation. That was a unique event in modern history, driven by a change in the structure of exchange rates, demographics, oil price shocks, expansive fiscal policies, as well as monetary policy errors. However, there are signs that some of the factors keeping inflation very low are abating. A sustained move back to the 2% to 3% range would represent a significant change from where inflation has been over the past 10 years.
Demographics, deglobalization, the dollar and deficits
Demographic trends have contributed to the low-inflation story of the past few decades. As populations age, demand for goods and services tends to slow, resulting in lower GDP growth and lower inflation.
The demographic “age wave” often cited to illustrate this relationship looks at the ratio of young to middle-aged workers. When the rate of growth in young workers is rising relative to the middle-aged and older workers, growth and inflation tend to rise.
Younger people are in their “spending years” — forming households, buying home, appliances, autos, etc. — driving up consumption. In contrast, middle-aged workers tend to save more.
While the aging and retirement of the baby boom generation is still a potential overhang on growth and inflation, the ratio of young to middle-aged workers has been rising for a few years. That should mean stronger aggregate demand, all else being equal.
Of course, all else is never really equal, and it looks like the financial crisis and the pandemic may have tempered demand from younger workers, but the trend suggests that much of the pressure on inflation from demographics may have run its course.
Downward pressure on wages likely has also contributed to the low-inflation environment. Several factors including globalization, the declining trend in unionization, and technological advancement likely have accounted for slow wage growth for a large group of workers.
Labor’s share of overall GDP has been falling for many years, a trend that translates into less spending power for consumers. While it’s far from certain, a case can be made that this trend may also have run its course.
The opening up of Eastern Europe to the world economy after the fall of the Berlin Wall in 1989, and China joining the World Trade Organization in 2001, added large numbers of workers to the global economy at low wages. Even absent policies that suggest “deglobalization,” it seems very unlikely that the global labor supply increase of the 1990-2020 era will be repeated.
The downtrend in the dollar, if it is sustained, is also potentially supportive to rising inflation. A weaker currency tends to raise inflation by pushing up the cost of imports and to boost growth by making exported goods more competitive.
On a trade-weighted basis, the dollar had been rising for about 10 years until last spring when the Fed shifted to its very easy policy stance. We expect it to continue moving lower as a result of the decline in real interest rates in the U.S. and rising external deficits that need to be financed with foreign capital. A weaker currency should provide some support for higher growth and inflation.
What should investors consider now?
Here are a few steps you can take if inflation rises modestly, as we expect:
1. Keep average duration low
When it comes to investing in bonds in an environment of rising inflation, it is important to keep an eye on portfolio duration, or the sensitivity to rising interest rates. We suggest keeping the average duration in your portfolio below average, or below the benchmark, to mitigate the risk of rising interest rates.
2. Consider TIPS
Historically, Treasury bills have tended to keep up with inflation because they have such short maturities and can be rolled over frequently as the Fed hikes short-term interest rates. However, with the Fed indicating it will keep short-term rates near zero even as inflation rises, investors may want to consider shifting some Treasury holdings into Treasury Inflation-Protected Securities (TIPS), which are designed to keep pace with inflation.
TIPS have a fixed coupon rate, but receive an adjustment to the principal amount based on the inflation rate. Although the coupon rate remains fixed, the coupon payment rises with the rise in the principal. This provides the benefit of an income stream linked directly to inflation and the potential for more principal at maturity in a rising inflation environment.
3. Add more yield when appropriate
Because we don’t anticipate very high inflation, we suggest using periods of rising yields to add medium- to long-term bonds over the next few years to generate more income in portfolios. In past rising-rate cycles, long-term rates typically moved up before short-term rates, causing the yield curve to steepen until rates approach the expected peak in the federal funds rate.
As the Fed begins to tighten policy by raising short-term interest rates, the yield gap narrows, and the yield curve flattens. Because long-term rates represent the average of short-term rates plus a risk premium (term premium), short and long-term yields tend to converge at market peaks. Often, investors wait too long to add more yield to portfolios.
As a result, they can end up missing the opportunity to lock in those higher coupons. We suggest strategies like bond ladders or barbells (which divides the allocation between short- and intermediate-term bonds) to help “average in” to higher yields over time. Bond ladders are particularly useful because they help balance the desire for income today with a tendency to want to time the market.
Looking across the fixed income market, it is important to understand how different sub-asset classes have performed in both low and high inflationary time periods. Treasury bills tend to perform well during high inflationary periods because maturities are shorter and the yields rise when the Federal Reserve hikes rates.
Conversely, when inflation doesn’t materialize and the Fed doesn’t see a need to hike rates, Treasury bills offer little upside in yield. This is another reason why we like bond ladders and barbells: The investor doesn’t “miss out” if inflation doesn’t come to fruition.
Another way to think about the problem of where to invest in an inflationary environment is through an outperformance lens. In many cases, by taking on more risk, you earn a higher yield that stands a better chance at outperforming inflation. For instance, in corporate credit, coupons and yields are higher to compensate for default risk. If you are willing and able to take on that additional risk, then you can potentially outperform inflation.
However, we should note that despite current low yields and the risk of higher inflation, there are still good reasons to hold some Treasuries in a portfolio. They provide diversification from stocks, tend to dampen portfolio volatility and preserve capital.
Lawton Retirement Plan Consultants, LLC (LRPC) Monday Morning Minute is crafted to provide decision-makers with important information about the economy, investments and corporate retirement plans in a format that allows a reader to consume the information in less than 60 seconds. As an independent, objective investment adviser, LRPC has access to many sources of research and shares the best and most relevant information with its readers each week.
Lawton Retirement Plan Consultants, LLC (LRPC) is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to employer retirement plan sponsors. The firm specializes in sustainable investment strategies for retirement plans that incorporate Socially Responsible Investment (SRI) factors and Environmental, Social and Governance (ESG) elements. LRPC currently has contracts in place to provide consulting services on more than a half billion dollars in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or firstname.lastname@example.org or visit the firm’s website at https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, a plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges, and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.
Additional Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request. Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Diversification strategies do not ensure a profit and do not protect against losses in declining markets. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk. The RBC Enhanced Commodity Index is a broad based commodity index providing exposure to energy, precious metals, base metals, grains, livestock, and soft commodities. Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the U.S. government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the U.S. government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation. A bond ladder, depending on the types and amount of securities within the ladder, may not ensure adequate diversification of your investment portfolio. This potential lack of diversification may result in heightened volatility of the value of your portfolio. You must perform your own evaluation of whether a bond ladder and the securities held within it are consistent with your investment objective, risk tolerance and financial circumstances. Commodity-related products carry a high level of risk and are not suitable for all investors. Commodity-related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions. International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks. Currencies are speculative, very volatile and are not suitable for all investors. The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party. Investing involves risk, including loss of principal.