BBH Inflation-Indexed Fixed Income Quarterly Strategy Update – 2Q 2021

June 30, 2021
Portfolio Managers, James Evans and Jorge Aseff, provide an analysis of the investment environment and most recent quarter-end results of the Inflation-Indexed Fixed Income strategy.

Inflation is here, but for how long?

 As expected, higher inflation arrived in Q2 2021. The rollout of effective vaccines and massive economic stimulus sustained consumers and investors’ optimism for another quarter. Higher inflation prints fueled further an already heated debate about its permanence. Is higher inflation here to stay? For how long? At what point does inflation exceed the Federal Reserve’s (Fed) tolerance and they begin applying the brakes? We answer these and other frequently asked questions in our quarterly update to share our views on current inflation dynamics and the path ahead.

Markets and the economy

The almost uninterrupted rise in breakeven inflation rates (breakevens) that began in late March 2020 ended in mid-May, with 5-year breakevens peaking at 2.76% and 10-year breakevens at 2.56% (they began the year at 1.96% and 1.98%, respectively). In the last 6 weeks of Q2, 5- and 10-year breakevens gave back some of these gains and finished the quarter at 2.5% and 2.3%, respectively. Even though breakevens declined slightly, TIPS outperformed nominal Treasuries thanks to large inflation accruals. The real yield curve flattened in Q2, offsetting some of the increase in 10- and 30-year real rates. Flows into TIPS-related ETFs remained steady. May’s $3.4 billion flow into TIPS funds is the largest monthly value in our dataset and brought year-to-date (YTD) flows to over $16 billion by the end of Q2.

Boosted by one of the largest and most coordinated policy efforts, the U.S. economy accelerated further in Q2. Forecasts of real Gross Domestic Product (GDP) growth were revised upward across the board; estimates of annualized Q2 growth are above 8% in some cases and over 6% for all of 2021. At this pace, real GDP is set to exceed its pre-COVID peak just one year after March 20, 2020, when a global pandemic shut the economy down. The labor market improved considerably as well. The unemployment rate is at 5.9% and the number of unemployed persons is 9.5 million. Both are far below the April 2020 peak, but still have room to recover to their pre-pandemic levels of 3.5% and 5.7 million, respectively.

  Real Yields Breakevens
  5 Yr 10 Yr 30 Yr 5 Yr 10 Yr 30 Yr
Levels (%)
6/30/2021
-1.6 -0.9 -0.2 2.5 2.3 2.3
Changes (Bps.)            
Q2 12 -24 -28 -10 -4 -3
YTD -1 21 19 53 35 28
Last 12M -74 -17 -2 133 100 72
Date reported as of June 30, 2021
Sources: Bloomberg and BBH Analysis

In June, the Fed conducted its fourth Federal Open Market Committee (FOMC) meeting of 2021. Although the post-meeting statement did not show significant deviations from April’s statement, investors were surprised by the shift in the median number of hikes policymakers expect by the end of 2023, which moved from 0 to 2. This perceived pivot away from the Fed’s dovish stance led 10-year real yields to rise almost 20 basis points, and although rates rallied subsequently, futures markets are now expecting lift-off in early 2023.

Performance and positioning

On an absolute basis, our TIPS portfolios returned 3.25% in Q2, bringing YTD returns to 1.96%. On a relative basis we finished the quarter a few basis points ahead, increasing YTD performance to 23 basis points over the benchmarks. Even though economic growth remained robust and inflation accelerated, the selloff in real rates switched directions in Q2. As a result, our duration underweight detracted from YTD performance. To benefit from roll-down, we concentrated positions in the 3- to 8-year part of the curve. This strategy added to performance and acted as a partial offset. As we start Q3, given valuations and the seasonal patterns, we are neutral on breakevens. On rates, we still believe that economic momentum and additional policy stimulus will exert upward pressure, and thus we retain our short duration position.


Exhibit 1: Histogram showing the percentage of times CPI YoY change belonged to a given range since 1960. For example, 73% CPI YoY fell between 0 and 5%.

Inflation

Headline Consumer Price Index (CPI) for May 2021 was 5% year-over-year, a level last seen in 2008 when oil prices reached $140 per barrel. Although not a tail event, 5% CPI is a bit of an outlier in inflation history. Inflation data beginning in 1960 show that 73% of the time headline CPI remained in the 1-5% range, narrower ranges such as 4-to-5% and 5-to-6% occurred only 10% and 5% of the time, respectively. Annual core CPI at 3.8% is at multi-decade highs as we have not seen such levels since the early 1990s.

The Fed’s preferred measure of inflation, based on core Personal Consumption Expenditures, or Core PCE, reached 3.4% in May, exceeding 3% for the first time since the early 1990s. The Fed’s Average Inflation Targeting framework stipulates that the goal is to achieve 2% average inflation over time. They have been short on details to measure average inflation over time, but the current pace brings both the 3-year and the 5-year moving averages to 1.74%, leaving some room for policy to tolerate higher inflation for longer.

What is driving prices higher?

There are three main drivers behind today’s higher inflation. First, as the COVID-induced deflationary months from 2020 rolled off the year-over-year calculations, annual inflation mechanically jumped as those months were replaced by positive readings. (These are the so-called base effects.) Second, the reopening of the economy lifted aggregate demand as consumers spent record-high savings and direct income transfers in the form of unemployment insurance and other benefits. Third, supply bottlenecks and hiring difficulties hindered companies from responding with increased production in many industries.

Where is inflation concentrated?


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.


The chart shows a time series of Core PCE broken by COVID sensitivity. It shows that COVID-sensitive categories contributed the most to reduce inflation in spring 2020 and to increase inflation in spring 2021.

Higher inflation thus far is concentrated among COVID-related sectors. In April, about 80% of the increase in CPI came from categories such as used-car prices, airfares and lodging away from home. In May, the contribution of these categories fell to 64%. Core inflation measures produced by the Federal Reserve Bank of Atlanta, the Sticky Core CPI and the Flexible Core CPI (calculated based on the frequency with which prices fluctuate), show that flexible-price components such as apparel, lodging away from home, and used cars and trucks, dropped sharply as the pandemic set in, and climbed back quickly in recent months. An analogous exercise using Core PCE, shows a similar result. The contribution of COVID-sensitive components was minimal in the early months of the pandemic, but they dominate price increases today.

As the impact of COVID-sensitive components moderates, attention is shifting to shelter and rent in CPI, which represents 32% of the index and are typically associated with more sustained changes in prices. These components picked up some pace recently, posting a healthy 0.33% increase in May. Going forward, the increase in housing prices may add pressure on rent inflation, since at some point higher home prices may become higher rents.

Is higher inflation here to stay?

For a few months, this question has occupied the minds of academics, investors, and policymakers. The Fed remains confident that the recent surge in prices will be transitory. How do we approach this question? After all, there is nothing permanent except change. To be sure, there are four general inflation scenarios, as indicated by the slope of the thick black line in the Inflation Scenarios exhibits below:

The first two denote temporary deviations from a long-term inflation trend. In (a) inflation accelerates above-trend for some time, after which it slows down to below-trend until it reverts to its original trend. In (b), price increases accelerate for some time, after which higher prices continue growing at trend-inflation again, but from a higher base level. Scenario (c) depicts a scenario in which trend inflation increases, causing prices to increase at a higher rate for the foreseeable future. Case (d) illustrates accelerating inflation, as prices grow at ever increasing rates.


The exhibit illustrates four general inflation scenarios. (a) A scenario in which inflation accelerates above the current trend rate, and then decelerates below the current trend rate. Finally, it returns to the original trend rate; (b) a scenario in which inflation spikes temporarily and then it settles at the original trend rate, but at a higher base price level; (c) a scenario in which trend inflation increases permanently; and (d) a process of accelerating inflation in which prices grow at ever increasing rates.

Thus far, a transitory inflation uptick as in (a) and (b) seems more likely for a few reasons. Inflation drivers are primarily associated with COVID-related categories, which are now growing at more moderate rates. Therefore, scenario (a) provides a useful paradigm. The increase in shelter inflation could persist for longer, extending the duration of the above-trend inflation episode. However, prices would not grow indefinitely at a rate that is above the Fed’s target.  At some point the Fed would tighten policy, exerting downward pressure on prices until inflation reverts to its trend.

How transitory is transitory?

This is a difficult question. We cannot forecast the length of the current inflationary episode, but we think it is driven by the interaction of inflation expectations, labor costs, and Fed policy. The Fed operates under the assumption that when expectations are anchored near the 2% target, there is room to maneuver without meaningful and fundamental inflationary risks. For now, market-based inflation expectations remain near the Fed’s target. Inflation markets expect average inflation around 2.5% until 2026, and about 2.2% between 2026 and 2031. Survey-based inflation expectations are higher but display a similar path ahead. The University of Michigan 1- and 5-years ahead expectations are 4.8% and 2.8%, respectively.


This chart shows inflation expectations, as measured by the 5-year breakevens and
5-year breakevens 5 years forward, and Core PCE.


The charts shows a time series of wage growth as measured by the Federal Reserve Bank of Atlanta, currently oscillating around 3%.

The labor market continues to exhibit slack, with the employment level about 7 million below its pre-COVID peak, and wage growth remains around 3%. Existing hiring difficulties and sustained economic growth are beginning to manifest in increased pay in specific sectors; for example, in a rare move for retail, stores started to offer sign-on bonuses; but not yet across the board. Ultimately, if wage growth accelerates and labor markets become tighter, there is a risk that inflation expectations become unanchored, and higher inflation self-fulfilling; i.e., the expectation of higher prices leads to higher wages demanded, which in turn leads to businesses increasing prices, which raises expectations, and so on. We expect that in order to prevent this cycle from starting, the Fed will intervene. In fact, the June FOMC meeting marks the beginning of the Fed’s discussion of when to consider a less expansionary monetary policy. In fewer words, the Fed is on the case.

Conclusion

Higher inflation is here. The bigger question is whether it will persist. The debate around this question is far from settled, but the evidence for now conforms to the Fed’s narrative of a temporary uptick in inflation. How long will inflation stay above trend is not a question we think can be answered. Furthermore, unlike previous years, inflation risks are now on the upside, exacerbating the impact uncertainty around the temporal nature of higher inflation. Uncertainty creates opportunities for investors to add value with TIPS. As always, we will be ready to benefit from these opportunities with our time-tested strategies and disciplined investment process.

Sincerely,

James J. Evans, CFA
Portfolio Co-Manager

Jorge G. Aseff, PhD
Head of Quantitative Research

Performance As of June 30, 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) 3.26% 1.96% 6.41% 6.57% 4.21% 3.63% 5.85%
BBH Inflation-Indexed Fixed Income Composite (Net of Fees) 3.23% 1.89% 6.25% 6.41% 4.06% 3.48% 5.69%
Bloomberg Barclays U.S. TIPS Index
3.25% 1.73% 6.51% 6.53% 4.17% 3.40% 5.47%

* Returns are not annualized.
The Inflation-Indexed Fixed Income Composite inception date is 04/01/1997

Past performance does not guarantee future results.

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 objective of our Inflation-Indexed Fixed Income Strategy is to deliver excellent returns in excess of industry benchmarks through market cycles. The Composite included all 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. Accounts that subsequently fall below $9.25 million are excluded from the Composite. As of 10/1/2020, the Treasury Inflation Protected Securities Composite was renamed BBH Inflation-Indexed Fixed Income.

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-09723-2021-07-19                         Exp. Date 10/31/2021

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