BBH Inflation-Indexed Fixed Income Quarterly Strategy Update – 2Q 2022

June 30, 2022
Portfolio Co-Managers, James Evans & Jorge Aseff, provide an analysis of the investment environment and most recent quarter-end results of the Inflation-Indexed Fixed Income strategy.

A Separation

Over the last few quarters, rising inflation had lifted market-implied inflation expectations (breakevens) as well, but toward the end of 2Q22, breakevens declined rapidly. Why the separation? The inflation surprise delivered to investors in June proved to be a little too much for markets and policy makers. First, investors anticipated faster Federal Reserve (Fed) tightening, sending interest rates higher at record speeds. The Fed then delivered the first 75 basis points1 rate increase since 1994. After that, it did not take long for investors to price in the Fed’s re-energized commitment to price stability and recession fears emerged. The market narrative switched from inflation to recession, sending inflation expectations lower. As we will review below, inflation remains elevated and risks to the upside still exist, mainly in labor and rental markets. We believe current breakeven valuations offer attractive investment opportunities.

Markets

The year-over-year headline Consumer Price Index (CPI) for May rose to 8.6%, exceeding expectations and April’s CPI by 0.3%. The year-over-year core CPI also rose above expectations to 6.0%. The sudden realization that inflation did not peak in 1Q22 caused a strong reaction in bond and equity markets. In the bond market, the 2-year nominal rate increased more than 25 basis points in two of the three subsequent trading sessions. Such large daily moves in the 2-year rate had occurred only 16 times since the interest rate targeting era began in 1989. In equity markets, the S&P 500 lost more than 7% of its value in the days following the CPI announcement.

Over the quarter, the nominal yield curve shifted up by more than 100 basis points at the front end, and by 70 basis points at the 10-year maturity point. In the Treasury Inflation-Protected Securities (TIPS) market, the real yield curve experienced more pronounced increases, with shorter rates rising more than 150 basis points and intermediate-to-long rates by at least 100 basis points (see Exhibit I). As a result, TIPS were down 6% for the quarter in absolute terms, bringing year-to-date returns to -9%. Breakevens declined across all maturities and TIPS underperformed nominal Treasuries by about 2.3% (see Exhibit II). Flows into TIPS-related Exchange Traded Funds were a negative $2 billion in April and May, but positive in June, reducing the full-quarter outflow to a net of $1 billion.

Even though inflation reached multi-decade highs, investors have remained confident in the Fed’s ability to bring inflation back to more normal levels. Market-implied average inflation expected for 2022 to 2027 peaked at 3.75% in late 1Q22, while the average inflation expected for 2027 to 2032 peaked at 2.6% in early 2Q22. As of June 30th, these rates had come down to 2.6% and 2.0%, respectively. To preserve this confidence, investors believe the Fed will stay committed to higher rates until price stability returns.


Exhibit I: The exhibit shows the 2Q22 change in nominal Treasury yields, real yields, and market-implied inflation expectations (breakevens).


Exhibit II: The chart shows 5-year breakevens and 5-year breakevens 5 years forward. The date begins December 2019.

Performance and positioning

Our TIPS portfolios finished the quarter behind their benchmarks but stayed ahead by about 10 basis points year-to-date. Throughout the quarter we maintained an overall duration underweight with a flattening bias. This positioning was motivated by the tendency of rates to rise and the TIPS curve to flatten during tightening regimes. The positioning added to performance in 2Q22 as real yields sold off and flattened. Additionally, we held a position in 10-year nominal Treasuries across accounts in May that contributed to performance following the drop in 10-year breakevens.

The Fed, the economy, and inflation

The last time the Fed increased rates by 75 basis points was in November 1994. It was the penultimate move in a cycle that increased the Fed funds rate by 300 basis points. In stark contrast to today, core Personal Consumption Expenditures (PCE) inflation at the time was 4% below the Fed funds rate. The Fed’s objective at the time was to stay ahead of inflation given strong wage growth and a stellar economic performance. As Exhibit III shows, core PCE remained consistently below the Fed funds rate by a few percentage points. It was only after the Fed funds rate hit the zero lower bound during the Global Financial Crisis that inflation exceeded the Fed funds rate.


Exhibit III: The chart shows the Fed funds rate and Core PCE starting 1984. Before the 2008, the Fed funds rate was higher than Core PCE most of the time, often exceeding it by a few percentage points.

When the current tightening cycle began in March, core PCE was 5% higher than the policy rate. It was known the Fed would wait for the economy to recover from the COVID-induced recession before moving against inflation. But letting core PCE rise multiple percentage points above the policy rate means the Fed waited too long and now needs to catch up. Bond markets understood this well. Not surprisingly, during this Fed tightening cycle, rates increased much faster ahead of the Fed meetings than in past cycles. The 2-year rate increased 40 basis points on average in the 20 trading days before the 2022 Fed meetings. For comparison, the 2-year rate increased 15 basis points ahead of meetings in all tightening cycles between 1994 and 2018 (see Exhibit IV).


Exhibit IV: The chart compares changes in the 2-year interest rate ahead of Fed meetings this tightening cycle compared to all other tightening cycles back to 1994.

Tighter financial conditions such as higher mortgage rates and lower equity prices had more palpable effects on the economy in the quarter. High-frequency consumption data, based on credit card activity reported by the banking system, show consumers are cutting back on expenditures. Furthermore, the 3-month moving average of the Chicago Fed National Activity Index dropped to 0.2 in May, driven by contractions in the consumption and income categories. Although this indicator remains above the recession threshold of -0.7, the drop is significant given that consumption accounts for about two-thirds of U.S. Gross Domestic Product. The job market remained tight, with unemployment at 3.6% and wage growth at an all-time high of 6.1%. One sign the job market may be about to cool off is the number of unemployed persons per job opening, which remained at an all-time low of 0.5 since March. Overall, the job market will continue to exert pressure on aggregate prices.

What about inflation? As mentioned above, CPI exceeded expectations in May. Energy prices drove the monthly headline inflation rate of 1%, and Services drove the monthly core inflation rate of 0.6% (see Exhibit V). Within core services, Shelter (also known as housing) increased 0.6% in May. At 33% of CPI, Shelter is a key driver of core inflation. Going forward, elevated mortgage rates will likely push more people toward the rental market, keeping housing inflation a source of further price pressures for a few more quarters.


Exhibit V: The chart shows the contribution to monthly Core CPI broken down into goods (used vehicles and other goods) and services (shelter and other services).

Conclusion

The Fed’s commitment to contractionary policy and the associated increase in rates shifted the narrative from inflationary concerns to recession fears in a short period of time. The sell-off in rates from early June reversed almost completely by quarter end and market-implied inflation expectations returned to September 2021 levels. While some inflation relief may be coming from supply side factors, inflation risks to the upside remain. Breakeven inflation rates in the 2.0%-2.6% range present a good opportunity to increase allocations to TIPS.

Sincerely,
James J. Evans, CFA
Portfolio Co-Manager

Jorge G. Aseff, PhD
Portfolio Co-Manager

Performance as of June 30, 2022
  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) -6.48%
-8.88% -5.39%
2.97% 3.16%
1.86% 5.38%
BBH Inflation-Indexed Fixed Income Composite (Net of Fees) -6.52%  
-8.95% -5.53%  2.81% 3.00% 1.71% 5.22%
Bloomberg U.S. TIPS Index
-6.08% -8.92%
-5.14% 3.04%
3.21% 1.73%
5.02%

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

Past performance does not guarantee future results.
Sources: BBH & Co. and Bloomberg

1 One “basis point” or “bp” is 1/100th of a percent (0.01% or 0.0001)

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. Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices.

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 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.

“Bloomberg®” and the Bloomberg indexes are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indexes (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Brown Brothers Harriman & Co (BBH). Bloomberg is not affiliated with BBH, and Bloomberg does not approve, endorse, review, or recommend the BBH Strategy. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to the strategy.

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.

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IM-11371-2022-07-19    Exp. Date 10/31/2022

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