U.S. Inflation Normalizing
In sharp contrast to the first quarter, fixed income investors finally balked at the historically low yields on offer in Europe and the U.S. This, combined with more constructive economic data, particularly in the U.S., led rates steadily higher in both Europe and the U.S. through much of the second quarter. The end result was a less-than-favorable environment for the absolute return of most fixed income sectors. U.S. TIPS fared better than nominal U.S. Treasuries in the second quarter, benefitting from modestly higher investor inflation expectations and the positive carry associated with improved inflation accruals as monthly Consumer Price Index (CPI) readings returned to positive territory. Despite this, the low starting point for real yields did not provide an ample buffer against their sizeable 25-50 basis point increase across the curve and absolute returns for U.S. TIPS were negative. As measured by the Barclays U.S. TIPS Index, U.S. TIPS returned -1.06% in the second quarter. The second quarter’s negative return erased much of the first quarter’s gains; however, the year-to-date total return for the asset class remained modestly positive at 0.34%.
We have believed for some time now that steadily improving economic conditions in the U.S. would eventually set the stage for more normal levels of domestic inflation (2.5%-3.5%). The evidence that we see continues to support this view. The most prominent headwind to inflation of late has been lower energy prices. After tumbling in the second-half of 2014, both oil and gasoline prices have leveled-off into a fairly narrow trading range this year. As a result, the impact of last year’s sharp price declines has largely run its course through the CPI and should not place additional downward pressure on the index unless prices fall further. The slow recovery in the U.S. labor market has also inhibited higher inflation since the Great Recession ended in 2009. Despite steady job growth over the past five years, and clear evidence of a tighter market, wage growth has remained modest until recently. In 2015, both anecdotal data and data released by the U.S. Bureau of Labor and Statistics are signaling that higher wages are finally beginning to take hold more broadly. Stronger wage growth has likely been the missing ingredient for more normal inflation in the U.S., and if it persists, we would expect to see it reflected in future inflation index readings and investor inflation expectations.
Despite the mounting economic evidence supporting more normal inflation in the U.S., investors remain skeptical. Both current and forward looking breakeven inflation rates indicate that investor inflation expectations are well below historic averages. Surely the uncertainty surrounding the recent events in Greece, China, and the pending shift to less accommodative monetary policy in the U.S. are keeping investors cautious and inflation expectations unusually low. As long-term, value-oriented investors, we see opportunity when lack of investor fortitude and/or market volatility leads to mispriced assets. We believe that inflation expectations remain too low given solid economic fundamentals and are likely to trend back towards more historic norms in the U.S. If actual inflation and inflation expectations simply trend back towards historic norms, the asset class should perform quite well relative to nominal government bonds.
The second quarter was a good one for the relative performance of the BBH U.S. TIPS strategy. Much of our research in the inflation-linked securities markets is focused on identifying consistent and repeatable patterns that can be profitably exploited. One of the more reliable patterns we have observed over the years is the tendency for breakeven inflation rates to rise and the real yield curve to steepen in the first half of the calendar year. Our work suggests that this pattern is the result of an anticipated increase in demand for gasoline – an important component of the CPI – as the summer driving season approaches. We have also observed that this pattern often reverses in the second-half of the year. Having identified these seasonal patterns, we typically position client portfolios to benefit from these tendencies. So far this year, the pattern has played out according to script. The real yield curve has steepened and breakeven inflation rates have also moved higher consistent with the seasonal observations we have made in the past. We positioned our client portfolios to benefit from this seasonal pattern during the quarter which added meaningfully to relative performance.
Positioning for a steeper yield curve involves concentrating portfolio holdings in intermediate maturity securities. This segment of the yield curve tends to be fairly steep affording us an additional opportunity to enhance relative returns by augmenting portfolio roll down versus the performance benchmark. We define roll down as the price appreciation that occurs as a security ages along a positively sloped yield curve. The favorable roll down position we maintained in client portfolios from our concentration in intermediate maturity securities was also additive to relative returns during the second quarter.
We continue to believe that real yields remain below fair value given the solid economic fundamentals present in the U.S. As a result, we expected real yields would continue to trend higher and tactically maintained short duration positions during the quarter. This position also benefitted relative performance.
Entering the second half of the year, we have repositioned portfolios for the seasonal patterns that typically flatten the yield curve. Elevated volatility seems likely as the saga in Greece unfolds and the Fed contemplates raising rates. An increase in volatility often expands the prospects to employ our tactical trading strategies and we will be vigilant for opportunities in the coming months. We continue to view inflation breakeven rates at or below 2% as attractive relative to nominal government bonds. As a result, we maintain TIPS as reserves in lieu of nominal U.S. Treasury securities in many of our taxable, non-TIPS portfolios, and may tactically position for higher breakeven inflation rates in our TIPS strategies in the coming months.
James J. Evans, CFA
Inflation-Indexed Bonds Portfolio Manager