Bryan Dooley

Inflation expectations just reached their highest levels in a decade and that has some investors on edge. Every week we see additional news coverage about resurgent inflation and rising longer-term interest rates.

In the world of fixed income, interest rates and bond prices tend to move in the opposite direction making some investors more concerned about the declining value of their bond funds. Stocks, too, may be impacted in a slightly different way. Already, rising input costs have begun to crimp profit margins and growth stock valuation multiples may be at risk next.

Inflation expectations have been stoked this year by the increasing likelihood of a large US fiscal stimulus package, early signs of progress for vaccine rollouts and pent-up demand from consumers previously stuck at home. Pent-up demand was evident in last month’s US retail sales report which posted a surprisingly sharp 5.3% month-over-month increase, blowing away consensus economists’ estimates for just a 1.1% improvement.

According to Bloomberg data, the inflation rate, as measured by the Consumer Price Index (CPI), is expected to rise from 1.2% in 2020 to 2.2% this year. Economists disagree on the exact number, but overall forecasts have been on the upswing. For example, Moody’s Analytics is looking for a 2.9% inflation rate in 2021, while PNC Financial is calling for a 1.6% rise.  The high degree of forecast dispersion is due to the numerous uncertainties involved in the reopening process.

The International Monetary Fund (IMF) weighed in on reopening challenges in its latest report: “The softening in early 2021 is expected to give way to rising momentum in the second quarter as vaccines and therapies become more readily available, allowing contact intensive activity to strengthen.” However, “surging infections in late 2020 (including from new variants of the virus), renewed lockdowns, logistical problems with vaccine distribution, and uncertainty about take-up are important counterpoints to favorable news.”

Besides the headline CPI number, analysts also pay attention to the ‘breakeven inflation rate’ used to gauge anticipated inflation levels. The breakeven rate is a market-based measure of expected inflation calculated by taking the difference between the yield of a regular US Treasury bond issue and an inflation-linked bond of the same maturity. Using current levels on the 10-year bonds reflects what market participants expect inflation to be over the next decade.

After a sharp spike in yields this month, the 10-year bond is currently yielding 1.36% while the current yield to maturity of the treasury inflation protected security (TIPS) bond is -0.80%. Taking the difference between the two market-based rates shows an expected inflation level of 2.16%, representing a substantial rise from below 1% in the spring of last year.

Other signs of higher inflation can be found in surging commodity prices and in the resurgent producer price index (PPI). Since last September, the Bloomberg Commodity Index, a composite index of commodity prices, has risen 22% and now surpasses its pre-pandemic level. Meanwhile, West Texas Intermediate oil prices punched up through $60 per barrel this month just as copper prices spiked over 15% in February, so far.

The producer price index is another popular inflation index which tracks the costs of goods from the viewpoint of the industries which make products rather than the consumers themselves. In January, the US PPI index increased by a seasonally adjusted 1.3% – the largest advance since the index was launched in December 2009. Whether or not higher manufacturer’s prices show up in consumer prices ultimately depends upon final demand strength and if producers are willing and able to absorb the costs.

While recent increases in inflation expectations and commodity prices are concerning, some economists argue that the snap back in prices reflects more of a supply bottleneck from the lockdown which could quickly dissipate as activity continues to normalise. Also, commodity prices might be kept in check by additional supply such as new oil rigs coming back onstream in the energy market. A time-tested economic axiom states that nothing solves higher prices, like higher prices.

The US Federal Reserve is closely watching inflation rates to determine if this year’s uptick is more of a short-term pop versus a longer-term process of creating sustained inflation. The Fed has made it clear that it welcomes an increase in inflation of up to 2% and maybe a bit higher. But inflation above that level on a non-transitory basis could eventually provoke a shift in central bank policy.

Still, the Fed’s other mandate of supporting full employment will likely receive a higher priority in the near to intermediate term. The US unemployment rate was 6.3% in January, far above its low of 3.5% posted early last year. Restoring businesses, pummeled by pandemic-related government mobility restrictions while bringing unemployed citizens back to work, will likely take priority over capping prices. Therefore, we do not expect any movement in short-term interest rates for the next several months.

Given the potential for further inflation, investors should consider having some inflation protection in their portfolios. These assets may include treasury inflation-protection securities (TIPS), real estate owned directly or through real estate investment trust (REIT), commodities and common stock of companies able to pass higher costs on to their consumers. Innovative companies which are disrupting traditional business models through cutting-edge technology and cheaper small-cap-value stocks are good bets in this environment.

Bryan Dooley, CFA, is Head of Portfolio Management at LOM Asset Management Ltd. Please contact LOM at 345-233-0100 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.

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1 COMMENT

  1. Good points, Bryan.
    However, couldn’t these data measure a real, not just nominal, increase in prices from real increases in demand and an increase in real interest rates? Could that explain a negative yield on the TIPS with a jump in the 10-yr causing such a spread? Are you assuming the Fed will continue to focus on employment and thereby monetize the Treasury debt needed in a budget-busting fiscal policy in its effort to risk inflation (currency devaluation) to bring up those who will lag in the recovery?
    ginnie