It’s hard being an investor. On any given day, there is something to worry about if you look hard enough. If a global pandemic wasn’t sufficient enough, investors are bombarded with news-inducing FOMO one day and fear-inducing volatility the next day.
Now investors have a new enemy that they haven’t had to contend with in decades: inflation. Ironically, these concerns are now mainstream topics of discussion. Perhaps this is because any concerns have been discounted for so long that the prevailing arguments have been that inflation was dead and no matter what governments and central banks do, inflation will never rise to damaging levels again.
Hmm, what have I said about believing in absolutes? In any case, should investors, even conservative bond investors, fear inflation? The answer isn’t a simple yes or no. Like most things in life, the answer requires some explanation and consideration. In this musing, I will explain why bond yields are rising (inflation rising/bond prices falling) and the circumstances surrounding this, and when investors should be worried about inflation and when they should not.
Backdrop
In my Great Hope for What Lies Ahead in 2021 Commentary, we identified the three macro themes of 2021; Recovery, Catch-Up, and Accommodation. Fair to say that those themes have played out in Q1 as predicted with no significant hiccups. Most economic indicators suggest the global economy is recovering at a robust pace, much faster than after the global financial crisis (GFC).
U.S. and Canadian employment, as an example, has enjoyed a healthy recovery from last spring’s dramatic and swift economic destruction. Thanks to government support, consumers are in relatively good financial health, with household net worth near record highs and the debt-to-disposable income ratio back around the 2000 level. As governments continue their vaccination efforts, we believe that consumers will have a lot of pent-up desire to spend and will look to put the savings they have built up to work once economies re-open. That’s the good news.
As bond investors have realized this past quarter, what is good for the equity markets and the economy may not be so good for bond investors, at least not so in the short term. Investors with fixed-income portfolios will be noticing that their bonds fell in value over the quarter. This was due to bond investors demanding higher yields in anticipation or expectation of rising rates in the future. To be clear, the Bank of Canada and the U.S. Federal Reserve have categorically stipulated that they have no plans to raise their policy rates in the next two to three years. So, why have real rates risen? The short answer is that bond investors believe that inflation will be higher than expected and therefore, will force central banks to raise rates earlier than planned. Why do bond investors believe this to be so? Three words: massive fiscal stimulus.
Have Governments Gone Too Far?
The ongoing debate in financial markets is whether the new U.S. federal administration’s massive $1.9 trillion stimulus package, the latest in a series of stimulus efforts ($2.9 trillion in 2020 plus $1 trillion in infrastructure spending for a total of $6 trillion) has gone too far relative to the size of the economic problem. The overriding concern is that the sheer size of the stimulus could potentially turbo charge the economy and hence consumer prices, resulting in unstable economic conditions that will upend bond and equity markets.
Those who are fearful of the impact of these massive stimulus efforts point out that the unemployment benefits and tax credits are five times larger than the shortfall in wages and salaries. Others, like Nobel Laureate economist Paul Krugman, reject the notion that inflation will get out of control like it did in the 1970s. As Krugman states, it took a decade of “screwing up to get to that pass.” Neither my team or I, nor anyone else can predict with any degree of certainty whether governments and central banks will “screw up” and by how much, nor do we want to debate or argue about economic technicalities like output gaps and multiplier effects. We will leave those debates to the economists, philosophers, and pundits. Instead, we will focus on the real-world consequences and manage our portfolios accordingly.
Transitory or Sustained Inflation
As the global economy continues along a path of recovery over the next several months, inflation will rise sharply in every major economy (albeit starting from a historically low base), driven by a rebound in energy inflation, tax changes, and supply shortages. On average, CPI inflation in the advanced economies looks set to rise from 1.1% in February to 2.6% in May (source: Capital Economics). With the global economy expected to record the strongest GDP growth performance since 1984 (at 7% in 2021), this increase in inflation is not unexpected and has been widely predicted by global central banks. Should we be worried as the bond markets? The answer depends on whether inflation will be transitory or sustained.
Transitory Inflation Scenario
I know that many of you are tired of being locked inside and may take the end of the pandemic as an occasion to spend on leisure and hospitality in ways you were not otherwise able or willing to do. This surge in spending will create inflationary pressures in selected sectors (eg. restaurants), as unseen capacity bottlenecks are hit by a sudden and substantial increase in demand for travel, hospitality, and related consumption. If demand increases more quickly than capacity can return, prices may rise, and we may soon see significant one-off increases in inflation related to this consumption. However, this will likely only be for a short period. Inflation from short-term capacity constraints is something of a common occurrence, even in the middle of recessions. Transitory inflation indicates little about the overall economy’s health and next to nothing about the state of the labour market.
Persistent Inflation Scenario
Persistent inflation occurs when the effects of too-low unemployment, coupled with stronger than typical household finances, pave the way for more persistent inflationary pressures. This is the scenario when investors should have inflation anxiety: that increased financial well-being will lead to strong household consumption in a manner that creates a positive feedback loop on wages and unit costs (i.e. higher than usual demand increases inflation, which causes workers to demand higher wages, which further increases in demand, inflation and so forth). In the past, the fear of persistent inflation has been used to justify or suggest pre-emptive rate hikes shortly after the beginning of an economic recovery – sometimes stifling growth. Today, the global economy can’t afford any policy missteps. What is most important about this scenario and which seems unlikely given the degree and composition of labour market damage is how to distinguish persistent inflation from transitory inflation.
What We Think Will Happen Over the Next Several Months
Over the next several months, we believe that the following scenarios will play out and name the indicators that could cause us to change our views:
- Demand and Capacity – Supply shortages will boost inflation in most developed markets over the next three to six months, but underlying demand weakness will see core inflation fall back.
- Labour Markets – Persistent slack in the labour market will ensure that wage increases remain subdued.
- Commodity Prices – Higher oil prices will cause energy inflation to surge in the next few months, boosting headline inflation rates significantly, but this effect will reverse in 2022.
- Monetary Conditions and Policy – The explosion of central bank balance sheets has led many to fear a persistent rise in inflation. We doubt that this will happen in the near term, at least.
- Inflation Expectations – Inflation expectations have risen sharply, particularly for the U.S., but they are still consistent with central banks’ targets. If inflation expectations diverge significantly from what central banks have communicated, inflation could become a self-fulfilling prophecy. We believe that central banks have all the tools and the ability to manage the economy ably and will not repeat the mistakes of the 1970s.
How We’ve Positioned Our Portfolios
In my January 2021 commentary, I laid out our positioning in our portfolios. To recap, we believed and continue to believe that the recovery in activity and ongoing improvement in corporate profits support a rebound in cyclically sensitive assets and economic regions, such as Europe, Japan, and EMs, which have meaningfully lagged market leaders like big tech since the market bottom in March. We positioned our portfolios to capitalize on this theme. In addition, in our fixed-income exposure, we are and have been positioned as follows:
1. Increased Exposure to Alternatives
We have embraced “alternative yielding” asset classes for quite some time now and have recently – across all of our portfolio families – reduced our Canadian investment-grade fixed-income exposure and increased our allocations to strategies that invest in real estate, high yield, currencies, and foreign bonds. Each of these can provide short-term, long-term, and/or diversification benefits.
Speaking of equities, we have been selective in our equity exposure, ensuring that we look through our equity strategies and understand how they will perform in the current environment. Equities can be inflation hedges, but they need to be the right kind of equities with pricing power (e.g. materials, energy, and residential real estate). Low-growth defensive equities and high-duration growth stocks will do poorly in high-inflation environments. The former because they are bond-like, producing steady dividends, but don’t have the ability to grow those dividends at a significant rate. Long-duration growth stocks are at risk because they trade at high multiples, and the earnings to justify those multiples are far out in the future. Accordingly, we have underweighted these equities in our portfolios.
2. Reduced Allocation to Canadian Fixed Income
We reduced our broad-based exposure to the Canadian fixed income market favouring high yield and global fixed income. Our broader fixed-income capabilities can take advantage of rising inflation and contribute positively to portfolios by utilizing instruments that produce positive returns in a rising inflation environment. Also, the exposure to foreign currencies and economies other than those of Canada and the U.S. enables the mandate to take advantage of uncorrelated returns to Canadian fixed income. Last but not least, our core Canadian fixed Income manager has the latitude to manage these interest rate risks for our investors by seeking out less interest-rate-sensitive holdings.
A final thought to leave you with: The current narrative in the bond market is that everyone hates bonds and, as a result, bond yields are too high. When market participants are overwhelmingly positive or negative, that leads me to believe that there has been an overreaction. So, don’t be distressed about your bond holdings. As I’ve said before, I don’t believe it to be a great time to be a bond investor, but it isn’t a terrible time either.
Until next time, stay safe and be well.
Corrado Tiralongo
Chief Investment Officer
Counsel Portfolio Services | IPC Private Wealth