BBH Inflation-Indexed Fixed Income Quarterly Strategy Update – 1Q 2021

March 31, 2021
Portfolio Manager, James Evans, provides an analysis of the investment environment and most recent quarter-end results of the Inflation-Indexed Fixed Income strategy.

Anchored?

Multiple waves of COVID infections battered the U.S. and global economies for much of last year, but the announcements of highly effective vaccines in the fall proved to be a major turning point from pessimism to optimism. The questions we now ask are not about the severity of the recession, but about the possibility of economic overheating and its potential inflationary consequences. Will economic growth, boosted by extraordinary and coordinated policy efforts, cause inflation and inflation expectations to become unanchored?

Markets

March 18th marked the one-year anniversary of the lows in breakeven inflation rates. At the time, 5- and 10-year breakeven rates were at 0.17% and 0.55%, respectively. Since then, breakevens have increased almost uninterruptedly; the 5-year rate increased 240 basis points1 and the 10-year rate increased 180 basis points. Over this period, TIPS outperformed nominal Treasuries. It is interesting to note that in the early stages of the recovery, breakevens rose as real yields trended down, with nominal rates little changed. That is, in the reflation trade, TIPS total returns were positive and outperformed nominal Treasuries. In Q1 2021, rising inflation concerns raised nominal rates faster than real rates. That is, in the reopening trade, TIPS total returns were negative, but still outperformed nominal Treasuries.

For the quarter, the 10-year breakeven rate rose 39 basis points to 2.4%, the highest level since 2013. In terms of total returns, the sell-off in real rates meant TIPS lost 1.5%, but they outperformed nominal Treasuries by about 3.5% on a duration-adjusted basis. Increased concerns about higher inflation in the future fueled demand for TIPS-related exchange traded funds (ETFs), generating net flows of $7 billion into the asset class in Q1. On a rolling basis, net flows into TIPS-related ETFs reached $8 billion in February 2021, the second-highest three-month inflow on record.

The table shows levels of real yields and break-event inflation rates as of 3/31/2021. It also shows changes in real yields and break-even inflation rates in Q1 2021 and from 3/23/2020 to 3/31/2021.
Real Yields and Breakevens
  Real Yields Breakevens
  5 Yr 10 Yr
30 Yr 5 Yr 10 Yr 30 Yr
Levels (%)
3/31/2021

-1.8

-0.6

0.1

2.6

2.4

2.3
Changes (bps)
Q1 2021
Since 3/18/2020


-13
-240

46
-120

47
-70

64
240

39
180

31
130
Data reported as of March 31, 2021
Sources: Bloomberg and BBH Analysis

Performance

In the quarter, our full-maturity TIPS portfolios outperformed their benchmarks by about 25-30 basis points. The main contribution to performance this quarter was the normalization of seasonal patterns. With energy prices on the rise, demand for short-maturity TIPS was strong. At the same time, positive economic news raised long-maturity real yields. The resulting steepening of the curve benefited our term structure positioning. In February, we observed a meaningful concession as we approached the 30-Year TIPS auction that worked well with our pre-auction underweight in that part of the curve. Our post-auction overweight in the 30-year part of the curve also added to performance.

The economy

In the last two quarters of 2020, the U.S. economy grew at annualized quarterly rates of 33.4% and 4.3%, respectively. This mitigated the recessionary impact of the COVID-induced lockdowns, netting a full-year gross domestic product (GDP) contraction of 2.4%. The unemployment rate, close to 15% less than a year ago, finished the quarter at 6%. Helped by strong performance of energy prices, the headline Consumer Price Index (CPI) rose in January and February. On an annual basis, headline CPI is at 1.7% and core CPI at 1.3%. We expect annual CPI to jump in April as the negative-inflation months from 2020 fall off the calculation of 12-month inflation. (More on this below.)

On March 11, the American Rescue Plan Act of 2021 was signed into law by the President. A $1.9 trillion fiscal stimulus program that includes $1,400 checks for individuals, state and local government aid, expanded unemployment insurance and unemployment benefits, and other forms of economic assistance. Considering this additional fiscal stimulus, the Federal Reserve (Fed) updated the Summary of Economic Projections released at the Federal Open Market Committee meeting of March 17. For 2021, the median projected GDP growth was revised from 4.2% to 6.5%, unemployment from 5% to 4.5%, and core personal consumption expenditures (Core PCE) inflation from 1.8% to 2.2%.

The economic contraction in the Global Financial Crisis (GFC) was not as deep as in the COVID recession and it took longer to unfold. Four quarters after the pre-GFC peak, GDP had not reached its trough. As the contraction of GDP continued and then reversed, increased fiscal spending also continued and then reversed. This time around, four quarters after the pre-COVID peak, GDP has retraced about 80% of the peak-to-trough GDP decline and a robust rebound is expected throughout 2021. On the fiscal side, the budget deficit is growing with much more substantial stimulus than the GFC and will not decline before 2022.


Compares the evolution of GDP around the pre-recession peak (normalized; i.e., peak = 100), in the Global Financial Crisis recession and in the COVID recession.


Compares the evolution of the federal budget deficit over the same periods.

Fiscal policies, orders of magnitude more expansionary than in previous downturns, and the Fed’s accommodation, have ignited a debate about the risk of overheating the economy and starting an inflationary process. Many policy makers, economists, and market participants describe environments in which policies will prove instrumental to get the economy back to full employment with only a transitory increase in inflation. Others foresee environments in which policy accommodation will prove excessive and trigger a process of accelerating inflation. Perhaps most prominently; Larry Summers, former Treasury Secretary and former Chair of the Council of Economic Advisors; referred to the economic policy environment as the least responsible in the last 40 years.

Inflation: The path ahead

As mentioned above, inflation will rise for mechanical reasons over the next few months. Monthly CPI prints in March, April, and May 2020 were negative. As these months are replaced by months with positive readings, CPI will experience an uptick. For instance, an average 0.25% of monthly inflation replacing the negative inflation months would bring headline CPI to 3.5%.

In previous Quarterly Updates, we discussed drivers of higher inflation embedded in the evolution of the current economic cycle. These drivers are beginning to take shape as vaccinated consumers emerging from the pandemic give rise to pent-up demand. Furthermore, additional government transfers increase the likelihood and the magnitude of a surge in consumption, exacerbating probable upward pressures on prices. Whether these dynamics result in a transitory increase in prices or lead to accelerated inflation is a difficult question and the subject of an ongoing discussion. On March 17, Chairman Powell provided a hint about how one might address this question when he said “having [inflation expectations] anchored at 2% is what gives us the ability to push hard when the economy is really weak.” But what if inflation expectations became unanchored? In that case, it is possible that inflation turns self-fulfilling; in the sense that workers anticipating higher costs of living, for instance, demand higher wages; forward-looking businesses raise prices; and so on.


The exhibit shows %MoM change and %YoY change in headline CPI. It also illustrates the impact of negative inflation in Mar, Apr, and May 2020 rolling off the annual CPI calculation on annual inflation.

How anchored are inflation expectations? There are two general types of inflation expectations: Market-implied measures such as breakeven rates of inflation and implied probabilities, and surveys of households and businesses. The 5-year breakeven rate implies investors expect inflation to average 2.6% between 2021 and 2026, and the 5-year breakeven rate 5 years forward implies investors expect average inflation around 2.25% between 2026 and 2031. The Fed of Minneapolis’ market-implied probabilities provides additional insight. They calculate that the likelihood of average inflation exceeding 3% over the next 5 years is 30%, up from 10% in December 2020. The New York Fed’s Survey of Consumer Expectations and the Survey of Professional Forecasters (SPF) have inflation expectations right around 3% and 2.2%, respectively.


Levels of two market-implied measures of inflation expectations. The 5-year break-even inflation rate, and the 5-year break-even inflation rate 5 years forward.


Three survey-based measures of inflation expectations. The Federal Reserve Bank of New York’s 1- and 3-year ahead expected inflation, and the Survey of Professional Forecasters’ 5-year CPI. Data covers January 2019 to March 2021.

Inflation forecasts, market-implied or survey-based, do not usually have a good record. We calculate that breakeven rates miss realized inflation on average by about 60 basis points in either direction, while surveys miss realized inflation on average by about 70 basis points, also in either direction. At current levels, professional forecasters seem to stand behind Powell’s statement more strongly than consumers and inflation markets. If expected inflation around 3% became a reality, the Fed may tolerate it for some time, but we do not think the Fed would be entirely comfortable, especially if expectations drift even higher.

Conclusion

We see above-target inflation in the future even beyond the calendar gyrations in the next months. The economic cycle, an expansionary policy mindset, and the reshaping of the global economic order present upside risks that, absent another large adverse exogenous shock, have no clear offsetting factor. But irrespective of the temporal nature of future inflation, the presence of elevated inflation uncertainty creates opportunities and increases TIPS valuations. As always, we will be ready to benefit from these opportunities with our time-tested investment strategies and disciplined investment process.

Sincerely,

James J. Evans, CFA
Portfolio Co-Manager

Jorge G. Aseff, PhD
Head of Quantitative Research

Composite performance and benchmark over 3 month, 1 year, 3 years, 5 years, 10 years, and since inception as of March 31, 2021.
Performance
As of March 31, 2021
  Total Returns
Average Annual Total Returns
Composite/Benchmark
3 Mo.*
YTD* 1 Yr. 3 Yr. 5 Yr. 10 Yr.
Since Inception
BBH Inflation-Indexed Fixed Income Composite (Gross of Fees) -1.26% -1.26% 7.21% 5.68% 3.91% 3.68% 5.77%
BBH Inflation-Indexed Fixed Income Composite (Net of Fees) -1.30% -1.30% 7.06% 5.52% 3.75% 3.52% 5.61%
Bloomberg Barclays U.S. TIPS Index -1.47% -1.47% 7.54% 5.67% 3.86% 3.44% 5.38%
* Returns are not annualized.
Sources: BBH & Co. and Bloomberg
Past performance does not guarantee future results.

1 The Strategy was previously called the BBH Inflation-Indexed Securities Strategy
Basis point (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in price or yield of 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.

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 Barclays 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.

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 the account whose investment guidelines allow the greatest flexibility to express active management positions. 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 Composite is comprised of 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. On 10/1/2020 the BBH Inflation-Indexed Securities Composite was renamed the BBH Inflation-Indexed Fixed Income Composite. Accounts are benchmarked to the Bloomberg Barclays U.S. TIPS Index or equivalent.

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term 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.2021. All rights reserved.

Not FDIC Insured          No Bank Guarantee          May Lose Money

IM-09395-2021-04-21           Exp. Date  07/31/2021

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