Inflated Pessimism

The protracted headwinds responsible for curtailing inflation both in the U.S. and abroad persisted in the third quarter. While growth in the U.S. has generally been steady at around 2.5%, growth abroad remains much weaker. In particular, investor concern has centered on China. As recent market volatility demonstrates, even modest declines in the growth prospects for the world’s second largest economy has far reaching global implications. This economic weakness in turn has led to significantly lower commodity prices and energy prices. In the U.S., the relative strength of its economy compared to the rest of the developed world has resulted in a stronger U.S. dollar, which increases U.S. consumer purchasing power for imported goods and services. The combination of these factors has pressured inflation and inflation expectations lower. Both TIPS mutual funds and exchange traded funds (ETF) experienced outflows during the quarter, and the selling contributed to higher real interest rates across the yield curve. As a result, the U.S. TIPS asset class performed poorly for the quarter, returning -1.15%, as measured by the Barclay’s U.S. TIPS Index, and underperforming comparable duration nominal U.S. Treasuries by several hundred basis points.

Year-over-year Consumer Price Index (CPI) inflation, has remained at or below 2% since 2012. During the past 12-months, CPI has dipped further to 0%, largely due to sharply lower energy prices. Oil prices have nearly been cut in half over the past four quarters leading to lower gasoline prices, which are a key driver of CPI. In just the third quarter alone, gasoline prices fell about 15% to $2.29/gallon according to AAA’s Daily National Gasoline Price Index for regular unleaded. The renewed decline in oil and gasoline prices in the third quarter will likely be a drag on the next few monthly CPI releases. Not surprisingly, this has resulted in lower investor inflation expectations. Five-, ten-, and thirty-year breakeven inflation rates ended the quarter at 1.07%, 1.43%, and 1.62% respectively, down 40 to 60 basis points1 across the curve, and near their lowest levels for the year. Forward looking investor expectations, as measured by the 5-year, 5-year forward breakeven inflation rate, were 50 basis points lower during the quarter finishing at 1.63%.

Inflation expectations, as with many forward looking market indicators, must be observed with caution as they can be biased by current market conditions and do not always accurately forecast future outcomes. That being said, the 5-year, 5-year forward is a measure closely watched by the Federal Reserve and the current level must give them pause. Effectively, a forward looking breakeven inflation rate well below 2% implies that investors do not believe the Federal Reserve will successfully achieve their long-run stated inflation target of 2%. Said differently, investors remain quite gloomy about prospective inflation, despite sustained economic growth in the U.S., steady job growth in the U.S. and significant monetary accommodation not only in the U.S., but also in Europe, Japan, and China. Low investor inflation expectations likely had a hand in the Federal Reserve’s reluctance to move forward with a September rate hike that they appeared to favor only a few months earlier.

Contrary to investor behavior during the quarter, a more gradual pace of Federal Reserve tightening should ultimately lead to higher inflation expectations. We continue to believe that moderate growth and improving labor market conditions in the U.S. will eventually lead inflation to trend back toward levels more consistent with historic norms (2.5% to 3.5%). While energy prices may fall further, they will not likely repeat the magnitude of decline experienced over the past 12 months. As a result, gasoline prices should have a less detrimental impact on CPI once the most recent decline runs its course through the index in the next few months. The Core CPI, which excludes the volatile food and energy components, has been much more stable than the CPI, averaging 1.8% in recent years. This is a strong indication that CPI is likely to trend higher once the impact of lower gasoline prices subsides. If inflation and inflation expectations simply begin to trend back towards historic norms from current levels, as we expect they will, TIPS should meaningfully outperform nominal U.S. Treasury securities. TIPS offer investors insurance in the event that actual inflation exceeds current market expectations. In our view, insurance is best purchased when premiums are cheap. While it is intuitive that recent weakness in energy prices lowers short-term inflation expectations given their short time horizon, the repricing of forward breakeven inflation rates may present an opportunity for investors. At current breakeven inflation rates, we believe TIPS offer good value relative to nominal government bonds.

During the third quarter, our client portfolios modestly underperformed their respective performance benchmarks. We continued to maintain a tactical short duration position in light of an expected Federal Reserve rate hike. While the rate hike was delayed, real rates still moved higher during the quarter and the position proved to be additive to relative performance. Our proprietary research on seasonal trends indicates that the real yield curve typically flattens in the latter half of the year and breakeven inflation rates often fall. While we positioned for the flatter yield curve by concentrating portfolio holdings in short- intermediate and long maturities, we believed TIPS valuations were too compelling to position in nominal bonds. As a result, we maintained a long-breakeven position (i.e. Held additional TIPS duration hedged by nominal Treasury duration) in eligible accounts. Both the yield curve position and long-breakeven position detracted from performance during the quarter. With inflation prospects appearing more robust in the U.S., we did not hold any foreign inflation-indexed securities during the quarter.

We start the fourth quarter with much the same positioning we held throughout the third quarter. We continue to maintain a barbelled yield curve relative to the benchmark and remain positioned for both higher breakeven inflation rates and higher nominal U.S. Treasury rates in eligible accounts. While we may shift tactically away from our longer term views periodically, our conviction regarding TIPS valuations and seasonal patterns will likely keep us tilted in the direction of our current positions throughout the upcoming quarter.

Sincerely,

James J. Evans, CFA
Portfolio Manager

1 A unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.