BBH Inflation-Indexed Fixed Income Quarterly Strategy Update – 3Q 2021

September 30, 2021
Portfolio Managers, James Evans & Jorge Aseff, provide an analysis of the investment environment and most recent quarter-end results of the Inflation-Indexed Fixed Income strategy.

Bottlenecks: Larger and Lasting Longer

Inflation has been above 4% since April 2021, the first time in more than ten years that prices increased at such rate. The arrival of higher inflation did not surprise investors or policy makers. Higher inflation had been on the horizon since the economy reopened, consumers started to spend their lockdown savings, and supply chain bottlenecks emerged following the COVID-induced global economic shutdown. The drivers behind elevated inflation are still mostly transitory in nature; investors expect that demand will stabilize, and supply bottlenecks will ease. These expectations remain valid, but the likelihood of inflation lasting longer has gone up. In retrospect, the magnitude and breadth of supply bottlenecks were not fully appreciated, and even when inflation slows down, there is a risk it may settle well above the 2.0%-2.5% Federal Reserve’s comfort.

Markets and the economy

Break-even rates of inflation (breakevens) in the 10-year part of the term structure were almost unchanged in Q3. The Federal Open Market Committee (FOMC) meeting on September 22nd showed investors that the Fed’s stance is more hawkish than expected. As a result, 10-year breakevens dropped below 2.3% before recovering in the last trading sessions of the month. Although breakevens were little changed, strong inflation accruals helped TIPS outperform nominal Treasuries by 1.6% on a duration-adjusted basis during the quarter. Renewed risks of higher inflation for longer, resulting from consumer demand, supply chain bottlenecks, and commodity imbalances, led investors to TIPS-related Exchange-Traded Funds at a record pace. Net inflows into the asset class exceeded $10.5 billion in Q3, the highest quarterly net inflow in our dataset.

  Real Yields Breakevens
  5 Yr 10 Yr 30 Yr 5 Yr 10 Yr 30 Yr
Levels (%)
9/30/2021
-1.6 -0.9 -0.2 2.5 2.4 2.3
Changes (Bps.)            
Q3 0 -1 -5 3 4 0
YTD -1 20 14 57 39 28
Last 12M -39 6 10 104 74 51
Date reported as of September 30, 2021
Sources: Bloomberg and BBH Analysis

The U.S. economy continues to advance on solid footing, though at a slower pace than was expected earlier this year. Gross Domestic Product (GDP) exceeded its pre-COVID peak in Q2; the consensus growth forecast is 5.0% annualized for Q3, and 5.9% for full-year 2021. Nevertheless, the year-over-year growth outlook was revised down from the 7%-8% range. Most notably, the Fed’s September Summary of Economic Projections lowered its 2021 GDP growth forecast to 5.9% from 7% in June. We believe that these revisions reflect two underlying factors: The growing uncertainty introduced by the surge in COVID cases and the persistence of dislocations on the supply side.

Going into the recent FOMC meeting, investors’ eyes were on guidance regarding tapering of asset purchases. The meeting statement indicated that “if progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted.” Furthermore, during the press conference, Chair Powell mentioned that taper would likely end in the middle of 2022, which implies a faster-than-expected pace, since investors believed asset purchases would end by the fall. On rates lift-off, the committee members were split evenly at 9-9 on a hike happening as early as 2022, an upward shift compared to the June meeting.  

In the labor market, the unemployment rate fell to 4.8% in September, just 1.3% above its pre-pandemic low. Even though monthly nonfarm employment came below expectations, the U. S. economy generated an average of more than half a million jobs per month in 2021. Wage growth is approaching 4%, a level not seen since before the Global Financial Crisis, and average weekly hours remain on an upward trend. Additionally, skills mismatches are getting more common across industries. Note that wages of low-skill workers are rising faster than wages of high-skill workers. This usually indicates that the balance of power in the wage bargaining process is shifting toward the worker, traditionally an inflationary development.   


Exhibit 2: The left panel shows wage growth for low-skill workers passed that of high-skill workers for the first time in over a decade.

In the context of its revised monetary policy framework, the longer-run goals of the Fed establish that “in setting monetary policy, the Committee seeks over time to mitigate shortfalls of employment from the Committee’s assessment of its maximum level.” The Fed’s decision to focus on the shortfall in the level of employment relative to the pre-pandemic peak, currently at 5.5 million, seems to follow this revised framework. As the Fed waits for the employment shortfall to come to a level deemed consistent with maximum employment, there is a meaningful risk that policy will remain accommodative for too long.

Performance and positioning

On an absolute basis, our TIPS portfolios returned 1.5% in Q3, bringing YTD returns to 3.5%. On a relative basis, we finished the quarter behind the benchmark but remain ahead for the year. Since gasoline prices typically fall with the conclusion of the summer driving season, leading to weaker TIPS performance, we added nominal Treasuries to our TIPS portfolios. This year, energy prices remained robust, flows into TIPS were strong, and high inflation accruals helped TIPS outperform nominal Treasuries, impacting our relative performance. After the 30-year TIPS auction in August, we increased exposure to the long end of the real yield curve. This strategy contributed positively, but our duration positioning offset the gains. As we enter Q4 and policy makers focus on reducing monetary easing, we believe that upward pressure on real yields will intensify and remain underweight duration.

Inflation


Exhibit 3: The right panel shows headline year-over-year inflation is above 5% but market-implied inflation expectations remain around 2.5%.

The headline Consumer Price Index (CPI) gained 0.3% in August, down from 0.5% in July, resulting in a 5.3% increase in CPI over a year ago. Core CPI increased 0.1% in August, down from 0.3% in July, bringing the year-over-year change to 4%. (Numbers for September will be released on October 13th.) The Fed’s preferred measure of inflation, the change in core Personal Consumption Expenditures (Core PCE), is at 3.6%.

Even with elevated realized inflation, market-implied inflation expectations have barely budged and are not far from the Fed’s 2%-2.5% comfort zone. The 5-year break-even rate of inflation implies 2.6% annual inflation until 2026, and the corresponding rate 5 years forward implies 2.25% average inflation between 2026 and 2031. But the path ahead for inflation seems more uncertain today than even a few months ago. One reason is that supply chain bottlenecks are not yet easing. Even the Fed acknowledged that they did not expect bottlenecks to be as large or last as long. Supply chains depend on containers, ships, ports, trucks, and warehouses. The smooth flow from one link in the chain to the next requires predictability and accuracy, but instead supply chains are plagued with dislocations.

Start with containers. With demand surging in the U. S., shipping from China to the West Coast is six times more expensive than shipping from the West Coast to China. As a result, container owners find it profitable to ship empty containers back to China for more merchandise going to the West Coast. This leaves American exports at the port or inside rail cars. Since rail cars cannot unload their goods to go back inland to collect the next load, warehouses fill up. In addition, skills mismatches in the labor market afflicting the trucking industry further strain the supply chains. According to the Minnesota Trucking Association, longtime recruitment issues, early retirements, and COVID-canceled driving-school classes created a shortage of about 60,000 truck drivers. With the holiday season approaching, shoppers will click the checkout buttons faster and faster, exacerbating the impact of these bottlenecks. We should prepare for longer waits and higher prices as increased logistical costs find their way to consumers.

Conclusion

Looking back, restarting the economy after a global shutdown was not as simple as turning a switch back on. The surge in demand came at a time when producers and the global infrastructure is still dislocated. While supply chain bottlenecks will eventually ease, the likelihood of them clearing in a few months is low. The severity of the dislocations has increased the risk that inflation will stay elevated for longer. Moreover, even after inflation decelerates, it is not clear whether it will settle within the Fed’s comfort zone. This is a propitious environment for TIPS and its embedded protection against unexpected inflation. We see more strategic and tactical allocations to the asset class on the horizon.

Sincerely,

James J. Evans, CFA
Portfolio Co-Manager

Jorge G. Aseff, PhD
Head of Quantitative Research

Performance As of September 30, 2021
  Total
Returns
Average Annual
Total Returns
Composite/Benchmark 3 Mo.* YTD* 1 Yr. 3 Yr. 5 Yr. 10 Yr. Since
Inception
BBH Inflation-Indexed Fixed Income Composite (Gross of Fees) 1.50% 3.50% 4.87% 7.40% 4.32% 3.28% 5.85%
BBH Inflation-Indexed Fixed Income Composite (Net of Fees) 1.46% 3.38% 4.71% 7.24% 4.16% 3.13% 5.70%
Bloomberg U.S. TIPS Index
1.75% 3.51% 5.19% 7.44% 4.34% 3.12% 5.48%

* Returns are not annualized.
The Inflation-Indexed Fixed Income Composite inception date is 04/01/1997

Past performance does not guarantee future results.

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RISKS

The value of the portfolio can be affected by changes in interest rates, general market conditions and other political, social and economic developments. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.

Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, maturity, call and inflation risk; investments may be worth more or less than the original cost when redeemed.

Foreign investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards.

“Bloomberg®” and the Bloomberg indexes are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indexes (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Brown Brothers Harriman & Co (BBH). Bloomberg is not affiliated with BBH, and Bloomberg does not approve, endorse, review, or recommend the BBH Limited Duration Fund. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to the fund.

The Strategy may also invest in derivative instruments, investments whose values depend on the performance of the underlying security, assets, interest rate, index or currency and entail potentially higher volatility and risk of loss compared to traditional bond investments.

Holdings are subject to change. Totals may not sum due to rounding.

The Bloomberg U.S. TIPS Index includes all publicly issued, U.S. Treasury inflation-protected securities that have at least one year remaining to maturity, are rated investment grade, and have $250 million or more of outstanding face value. The index is not available for direct investment.

Effective duration is a measure of the portfolio’s return sensitivity to changes in interest rates.

Credits: Obligations such as bonds, notes, loans, leases and other forms of indebtedness, except for Cash and Cash Equivalents, issued by obligors other than the U.S. Government and its agencies, totaled at the level of the ultimate obligor or guarantor of the Obligation.

Data presented is that of a single representative account (“Representative Account”) that invests in the strategy. It is the account whose investment guidelines allow the greatest flexibility to express active management positions. It is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the Inflation-Indexed Fixed Income Strategy.

Brown Brothers Harriman Investment Management (“IM”), a division of Brown Brothers Harriman & Co (“BBH”), claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.

To receive additional information regarding IM, including a GIPS Composite Report for the strategy, contact John W. Ackler at 212 493-8247 or via email at john.ackler@bbh.com.

Gross of fee performance results for this composite do not reflect the deduction of investment advisory fees. Actual returns will be reduced by such fees. “Net” of fees performance results reflect the deduction of the maximum investment advisory fees. Returns include all dividends and interest, other income, realized and unrealized gain, are net of all brokerage commissions, execution costs, and without provision for federal or state income taxes. Results will vary among client accounts. Performance calculated in U.S. dollars.

The objective of our Inflation-Indexed Fixed Income Strategy is to deliver excellent returns in excess of industry benchmarks through market cycles. The Composite included all fully discretionary, fee-paying domestic accounts over $10 million with an emphasis on U.S. inflation indexed securities. May invest up to approximately 25% outside of U.S. inflation indexed securities, and a duration of approximately 7-9 years. Accounts that subsequently fall below $9.25 million are excluded from the Composite. As of 10/1/2020, the Treasury Inflation Protected Securities Composite was renamed BBH Inflation-Indexed Fixed Income.

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