BBH Inflation-Indexed Fixed Income Quarterly Strategy Update – 4Q 2023

December 31, 2023
  • Investment Management
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.

4Q Highlights

  • While inflation decelerated in Q4 2023, upside risks still exist.
  • TIPS remain an attractive alternative to nominal Treasuries with market-implied inflation expectations hovering around 2.15% and core CPI surpassing 3%.
  • Considering future rate cuts does not imply the economy is weak, it suggests the Fed would rather avoid excessive policy restraint.

Timing is Everything

Investors understand the importance of timing, but also understand that getting it right is almost impossible. Policy makers also struggle with timing. As the Federal Reserve (Fed) seeks to engineer a soft landing, timing a less restrictive policy stance will become crucial. The Fed seemed to signal a policy pivot at last December’s Federal Open Market Committee (FOMC) meeting. Time will tell whether this was opportune. In the aftermath, investors priced in 150 basis points of rate cuts in 2024, intermediate rates declined 40 basis points, equity prices soared, and therefore financial conditions eased. Ironically, easier financial conditions in the context of an economy close to full employment could reignite inflationary pressures.

In 2023, the 10-year nominal Treasury yield increased 1 basis point,1 concealing a volatile journey that saw the rate reaching 4.99% in October before retracing back to 3.88% at year end. Progress on inflation and softening employment growth in Q4 2023 elicited a rally across the yield curve, and in December, the FOMC meeting solidified investors’ convictions regarding the policy shift. Yields of Treasury Inflation-Protected Securities (TIPS) behaved similarly, falling about 50 basis points near the 10-year maturity sector to finish the year at 1.7%, just 14 basis points above its level at the beginning of the year (see Exhibit I). Market-implied inflation expectations (breakevens) at the 10-year maturity declined 12 basis points, finishing the year around 2.15%. For the year, the Bloomberg U.S. TIPS Index returned 3.9%, slightly behind nominal Treasuries.


Exhibit I: A table displaying real yields and breakevens at 2, 5, 10, and 30 year intervals for inflation-indexed markets as of December 31, 2023.

Performance and Positioning

First, a note on end-of-year pricing. A timing mismatch on December 29th detracted 20-25 basis points from relative performance. The Bloomberg U.S. TIPS Index, our benchmark, priced at 1 p.m. to determine monthly returns. In the next hour, bond yields rose almost 4 basis points before markets closed at 2 p.m. when our portfolios priced. Excluding this timing discrepancy, our positioning delivered 10 basis points of active return in Q4, closing the year in line with the benchmark.

We typically own 12-15 securities in our strategy, which given an upward sloping real yield curve, tend to concentrate around the steepest part of the curve to maximize the benefit of roll-down. In Q4 2023, with the real yield curve almost flat around intermediate maturities, term structure allocation and breakeven exposure were the main drivers of performance.

As the tightening cycle neared its end, we built a mild duration overweight and positioned the term structure to favor intermediate over long maturities. These positions added value in Q4 as short- and intermediate-maturity real yields declined more than long-maturity real yields. Entering 2024, we maintain a similar term structure allocation, but reduced duration exposure to neutral. Additionally, portfolios with futures authority are long 10-year breakevens.

Inflation and Monetary Policy

The decline in energy prices contributed to a decrease in headline Consumer Price Index (CPI) inflation during the quarter. Headline CPI grew 3.4% in 2023, while core CPI, excluding food and energy, grew 3.9% (see Exhibit II). This marks the first time since May 2021 that core CPI has fallen below 4%. As shown in Exhibit III, core CPI inflation continues to be driven by services; and within services, by shelter (housing constitutes 44% of core CPI). In 2023, housing inflation stood at 6.2%, demonstrating greater persistence than real-time indicators of rental costs, such as Zillow or CoreLogic, would suggest. Over the last three months, annualized housing inflation showed some progress reaching 4.9%, though it remains above its pre-pandemic average of 2.8%.


Exhibit II: A table displaying Headline CPI, Core CPI, PCE, and Core PCE data as of December 31, 2023.


Exhibit III: A bar graph displaying contributors to Core CPI inflation as of December 31, 2023, where Headline CPI grew 3.4% in 2023, while core CPI, excluding food and energy, grew 3.9%

The increase in the price index for personal consumption expenditures (PCE), the Fed’s preferred inflation measure, has improved too. Annualized price changes over the last three and six months in its core version indicate trend inflation is approaching the Fed’s 2% target. One factor contributing to the faster deceleration of PCE compared to CPI is the lighter housing weight in PCE. Normally, core CPI is 30-40 basis points higher than core PCE. Today, the gap is 70 basis points and will likely remain wide until housing inflation slows down. Furthermore, since the Fed targets PCE inflation and TIPS are indexed to CPI, lower PCE inflation could lead to a more dovish stance by the Fed, which along with CPI persistence would increase breakevens.

It is noteworthy that substantial progress in inflation has come at almost no cost to the labor market, potentially paving the way for the Fed to achieve a soft landing (see Exhibit IV). In 2023, the U.S. economy added 2.7 million jobs, averaging about 225,000 jobs per month. While this indicates a moderation from the pace of 400,000 jobs per month in 2022 and 600,000 jobs per month in 2021, the job market remains robust by historical standards. Labor market moderation is also evident in wage growth, which peaked at around 7% and has since stabilized at 5% for a few months (see Exhibit V). Furthermore, the gap between wage growth for job switchers and job stayers has narrowed, a common occurrence when hiring slows down.


Exhibit IV: A chart showing nonfarm payroll as of December 31, 2023, where substantial progress in inflation has come at almost no cost to the labor market.


Exhibit V: A graph showing wage growth from January 2013 through December 2023, peaking at around 7% and has since stabilized at 5%.

Considering future rate cuts does not imply the economy is weak, it suggests the Fed would rather avoid excessive policy restraint. This approach introduces potential upside risks to inflation. As mentioned, price pressures in services have not completely subsided. Moreover, estimates from the Federal Reserve Bank of San Francisco suggest consumers have about $290 billion in excess savings, which coupled with higher real income gains created by wage growth could exert further pressure on goods prices through increased consumption.

Conclusion

While inflation decelerated, particularly when measured by PCE, upside risks still exist. These risks are underscored by persistent pressures in the services sectors and eased financial conditions. The Fed’s timing may ultimately prove correct, but it raises concerns about exacerbating inflationary pressures more broadly. TIPS remain an attractive alternative to nominal Treasuries with breakevens hovering around 2.15% and core CPI surpassing 3%. This becomes especially pertinent as the Fed prepares to reduce monetary restraint, positioning TIPS as a compelling choice for investors seeking a hedge against unanticipated inflationary challenges.

Performance 
As of December 31, 2023

Composite/Benchmark

3 Mo.

YTD

1 Yr.

3 Yr.

5 Yr.

10 Yr.

Since Inception

BBH Inflation-Indexed Fixed Income Composite (Gross of Fees)

4.57%

3.60%

3.60%

-1.06%

3.09%

2.49%

5.09%

BBH Inflation-Indexed Fixed Income Composite (Net of Fees)

4.54%

3.45%

3.45%

-1.21%

2.93%

2.34%

4.93%

Bloomberg U.S. TIPS Index

4.71%

3.90%

3.90%

-1.00%

3.15%

2.42%

4.76%

               
Returns of less than one year are not annualized. The Inflation-Indexed Fixed Income Composite inception date is 04/01/1997. 
Sources: BBH & Co. and S&P
Past performance does not guarantee future results.

1 Basis points (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.

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. Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices.

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

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.

“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 Strategy.

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 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.

Brown Brothers Harriman & Co. (“BBH”) may be used to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2024. All rights reserved.

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