Breakevens Ride Trumps Coattails
The U.S. Presidential election results surprised many, and for the fixed income markets, it gave a long awaited jolt that pushed yields higher. While U.S. TIPS, like all other U.S. Treasuries, suffered negative returns due to the rise in yields, breakeven inflation rates increased sharply leading to strong relative returns versus nominal U.S. Treasury securities. For the last several years, we have believed that U.S. TIPS have offered attractive relative value to nominal U.S. Treasury securities. While valuations have improved during the past quarter, we continue to believe that market-implied inflation expectations remain too low as the policies of the incoming administration may provide a friendly backdrop for inflation bulls. Increasing investor interest and sector inflows, both in the market and at BBH, have added momentum to U.S. TIPS. Building upon the rally of breakeven inflation rates, we are once again pleased to deliver our clients strong returns relative to our benchmarks.
The U.S. Treasury market reaction to the U.S. Presidential election was sharp and swift. Donald Trump’s surprising victory brought to the forefront policies which investors initially view as favorable to U.S. growth, and potentially inflationary. Ten-year real yields, which began the quarter hovering near 0%, increased 50 basis points1 (bps). The 10-year breakeven inflation rate, which languished at historically low levels, increased 36 bps to 1.97%, its highest level since September 2014. The rise in real yields led to negative returns across the fixed income markets. U.S. TIPS were no different as the Barclays Capital U.S. TIPS index returned -2.41% in the quarter. However, when compared to equivalent maturity nominal U.S. Treasuries, U.S. TIPS exhibited excess returns (return in excess of U.S. Treasuries of the same duration) of 3%. Absolute returns for the year were strong at 4.68%.
The improving sentiment in U.S. TIPS is logical. The specifics of President-elect Trump’s policies are still to be determined, but with Republican victories in both the executive and legislative branches, his administration’s path to implementation is generally unencumbered. Many of the administration’s proposals, such as infrastructure spending, a build-up in defense, and tax cuts would likely be supportive of higher growth, higher deficits, and therefore risk higher inflation. Trade was also a key focus of the Trump campaign. Protectionist policies that could result in higher labor costs also raise inflation risks. Prospective border tax adjustments could also raise the cost of goods imports, which are heavily weighted in the Consumer Price Index (CPI). Actual inflation was also firmer in the fourth quarter, adding further support to increased inflation expectations. The headline CPI rose to 1.7% year-over-year, as of November. This was an increase from 1.1% three months prior, and 0.5% a year ago. Rising inflation was primarily driven by the waning impact of falling energy prices in 2015. Additionally, the Organization of the Petroleum Exporting Countries (OPEC) agreement to curb production led to firming energy prices, which helped support higher U.S. headline inflation readings. Year-over-year Core CPI, at a 2.1%, has remained steadily above 2%.
Rising investor interest in the sector has been evidenced by positive asset flows throughout the year, particularly in the fourth quarter. Shares outstanding in the widely followed TIPS Exchange-Traded Fund (ETF) increased 15% in the fourth quarter and 45% for the year. At BBH, we have also seen a meaningful uptick in search activity. We are proud to report that our own assets under management are up nearly $1 billion in new flows or commitments by year-end. The consistency of our strong relative results and the continuity of our investment team and process leave us well-positioned to capture new business as interest in the asset class builds.
In a quarter with sharp market moves, we are pleased that our client portfolios outperformed their respective benchmarks by 20 bps in the fourth quarter and 30 to 40 bps for the year. While political events played a large role in market returns in the fourth quarter, our strategy does not rely on predicting such events. Instead, valuations drive our portfolio positioning. We believed throughout much of the year that the strength of the U.S. economy was historically consistent with higher real yields and positioned portfolios to be modestly underweight real yield duration relative to their respective benchmarks. Real yields moved higher during the quarter driven by increased growth and Federal Reserve (Fed) tightening expectations, benefitting the short duration position. We have continued to make the case that inflation expectations are too low. Breakeven inflation rates remain below current levels of core inflation, well under the Fed’s inflation target, and well below historical levels of both inflation and inflation expectations. We positioned for this view in an overweight to longer maturity U.S. TIPS which benefited from the rise in breakeven inflation rates following the election.
Given the large move in the fourth quarter, how do U.S. TIPS look going forward? We continue to believe they possess good long-term relative value even after their recent strong performance. With Core CPI at 2.1%, breakeven inflation rates in all but the longest maturities trade below current levels of core inflation. Energy prices, a significant headwind in to Headline CPI in 2015, have stabilized with OPEC showing a willingness to reduce production to stem the supply glut. Despite the Fed’s decision in December to raise interest rates, inflation continues to fall short of their target (approximately 2.5% on Core CPI). This would argue for a more gradual reversal of Fed policy tightening. If Fed rate hikes were to exceed investor expectations this could be a potential headwind for U.S. TIPS. While monetary policy trends may not be as supportive for U.S. TIPS going forward, newly aggressive fiscal policy stimulus could catalyze new support.
As we enter the new year, we hold many of the same positions that worked well for us in the fourth quarter. Real yields have traded below our estimate of fair value, and even with the recent rise in rates, we are continuing to hold a shorter-than-benchmark duration profile. Seasonal patterns typically call for higher breakeven rates in the first half of the year. With valuations still providing long-term value and an incoming Trump administration indicating inflation-friendly policies, we continue to hold an overweight to breakeven inflation rates in those portfolios with the requisite flexibility. The U.S. TIPS market and the BBH TIPS Strategy enjoyed a strong year in 2016. With more interest in the asset class, long-term value still to be had, and inflation-friendly policies ahead, we are optimistic for continued strong results from the sector in 2017.
James J. Evans, CFA
Douglas R. Mark, CFA
1A unit that is equal to 1/100th of 1% and is used to denote the change in price or yield of a financial instrument.