Inflation ended the year under siege. Inflation expectations fell sharply during the quarter amid rapidly declining energy prices, building global growth worries, and a Fed laying the foundation for tightening. In fact, market-implied breakeven inflation rates now reside at levels last seen in the after math of the financial crisis. Does this drop in inflation expectations portend a secular shift in U.S. inflation and the risk of economic peril, or is this just another case of short-term market volatility creating a long-term value opportunity? We share our views below.
In the final quarter of 2014, TIPS returns were near-zero, remaining solidly positive for the year at 3.6%, as measured by the Barclays U.S. TIPS Index. This absolute performance belied the weakness in TIPS relative to nominal Treasuries which returned over 2% in the fourth quarter. Inflation expectations fell sharply during the quarter with the 10-year benchmark breakeven inflation rate down 30 basis points, ending the year at 1.68% — its lowest level since 2010.
In a move reminiscent of the oil price crash of 2008, crude plummeted over 40% during the quarter to $53 per barrel from $91. Reasons for the sharp decline were rooted in a growing supply/demand imbalance. Building supply from the U.S. shale oil boom and OPEC’s unwillingness to cut production to defend its market share amid weaker demand from slowing growth in Europe and Asia were all catalysts. Both in the U.S. and abroad, the implications from the sharp fall in oil prices may actually be quite positive. Lower energy prices should provide consumers with more disposable income and help stimulate global growth, though oil producing nations will feel deeply pained.
The Fed took the final step to end its Quantitative Easing program during the quarter, further pressuring U.S. TIPS. Later in the quarter, the Fed adjusted its forward guidance in a similar manner to that used in early 2004, the last time the Fed began preparing the market for rate hikes that ultimately took place six months later. Consistent with their view when energy prices were rising, the Fed has thus far viewed their decline as transitory. In fact, the Fed has recently emphasized the importance and stability of survey-based measures of inflation expectations compared to more volatile market-based measures.
In contrast to the overall market, our client portfolios ended the year strong, generally outperforming by 20 to 30 basis points. For the quarter, we positioned our client portfolios to avoid seasonal weakness in TIPS by reducing exposure to shorter maturities. Lower gasoline prices towards the end of the U.S. summer driving season typically lead to this seasonal weakness. While seasonally-adjusted CPI accounts for this factor, TIPS inflation accruals are derived from non-seasonally adjusted CPI. The downward direction of gasoline prices in the second half of the year occurred as it normally does; however, the magnitude was surprisingly large and we were happy to accrue the added performance benefits for our clients.
So where do we see TIPS valuations? The events of the fourth quarter understandably reduced short-term inflation expectations. Their impact on long-term inflation expectations, however, has been surprising. Experience tells us that large fluctuations in long-term market measures resulting from short-term volatility can be over-reaching and create opportunities for investors. One favored measure in the TIPS market is the 5-year, 5-year forward breakeven inflation rate, which measures inflation expectations for a five year period five years from now and in theory removes near-term inflation expectations and the volatility of energy prices associated with it. The theory is supported by the very weak correlation between crude oil prices and this forward breakeven rate. At its current level near 2%, this forward breakeven rate has fallen to a level only surpassed during the financial crisis. With the U.S. economy and labor markets on significantly better footing than during the financial crisis, such low inflation expectations feel overdone.
Turning to spot rates, the 10-year breakeven inflation rate at 1.68% is pricing in a dramatically lower inflation rate than experienced in any rolling 10-year period since the early 1960’s. Moreover, inflation implied by the TIPS market has frequently fallen short of actual inflation since the inception of the TIPS market in 1997. As value investors, we look forward to instances where short-term threats and volatility lead to attractive long-term opportunities. With long-term investor inflation expectations at levels well below what is normally experienced in the U.S., we believe this an instance where volatility has created an attractive opportunity in TIPS.
Entering 2015, we still view the yields on shorter maturities as expensive and below our estimates of fair value. We favor a bulleted yield curve position concentrated in 10-year maturities versus underweight positions in shorter maturities, which will likely continue to feel pressure from the fall in energy prices. Said differently, we view the 10-year maturity as offering better risk-adjusted return potential to take advantage of today’s compelling TIPS valuations.
We cannot completely disregard the economic signal the decline in market inflation expectations may be telling us; however, rather than trying to forecast the future, we focus our time studying and understanding valuations and repeatable patterns in the TIPS markets. We are accustomed to seeing short-maturity TIPS heavily impacted by energy price swings. The marked decline in long-term and in 5-year forward breakevens are much more interesting to us since, in theory, they should be largely immune to short-term fluctuations. Our research informs us that energy prices have only a small impact on long-term inflation, that TIPS valuations are unduly influenced by seasonal factors, and that today’s valuations already reflect the risk of a significant economic decline. Markets persistently overshoot in response to short-term factors and swings in sentiment. In TIPS, crisis-level valuations should spell opportunity, not threat.
James J. Evans, CFA
Inflation-Indexed Bonds Portfolio Manager
Douglas R. Mark, CFA
Inflation-Indexed Bonds Portfolio Manager / Trader