BBH Inflation-Indexed Fixed Income Quarterly Strategy Update – 3Q 2022

September 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.

3Q Highlights

  • The Fund outperformed its benchmarks by 15 basis points last quarter.1
  • Market-implied inflation expectations near 2% and inflation likely to stay elevated for longer present very attractive opportunities to acquire inflation protection. We think this provides opportunities for investors to create or add allocations to TIPS.

A New Hawk

In the second half of 2020, when supply chains were severely disrupted, coordinated fiscal and monetary expansions stimulated aggregate demand, causing prices to rise quickly. Given the nature of the process, Federal Reserve (Fed) Chair Jerome Powell qualified the resulting inflationary episode as transitory, expecting inflation to stabilize on its own as demand normalized and supply bottlenecks eased. That was then. Once Powell realized the persistence and severity of inflation, he found his inner hawk and decided to unleash a Great Tightening of interest rates to bring back price stability. For the first time since the era of interest rate targeting began, the Fed increased the funds rate by 75 basis points[1]in three consecutive meetings. The funds rate has increased 300 basis points since March, both the nominal and the real yield curves have increased by more than 200 basis points year-to-date, and rate volatility returned to levels not seen since before the Global Financial Crisis (GFC). The impact on financial markets has been devastating, with bonds and equities posting double-digit losses this year.

The quintessential barometer of fixed income markets is known as the Agg, short for the Bloomberg U.S. Aggregate Index. The Agg lost 4.75% in Q3 and 14.61% in 2022, the lowest return on record. These fixed income losses were driven by the selloff in Treasuries, which lost 4.3% in Q3 and 13% year-to-date. The size and speed of rate increases overwhelmed other sources of bond returns. Treasury Inflation Protected Securities (TIPS) constitute a perfect example, where the selloff in real rates eliminated more than 7% of inflation compensation embedded in TIPS. Real yields near the 10-year maturity increased more than 100 basis points in the quarter and more than 275 basis points year-to-date, causing TIPS to lose 5.14% in Q3 and 13.61% year-to-date. Market-implied inflation expectations (breakevens) at the 5-year maturity point dropped almost 50 basis points in Q3, falling to 2.16%, the same level touched in March 2021 (see Exhibit I).

 

Exhibit I: Inflation Market Update

  Real Yields   Breakevens  
  5 Yr 10 Yr 30 Yr 5 Yr 10 Yr 30 Yr
Levels (%)            
9/30/2022 1.98 1.67 1.73 2.16 2.15 2.09
Changes (Bps.)
MTD 122 96 75
-48 -33 -26
QTD 155 101 74 -46 -19 -12
YTD 364 278 219 -75 -44 -29
Consumer Price Index (CPI)
  Headline Food Energy Core Goods Services
MoM (%) 0.4 0.7 -2.6 0.6 0.3 0.7
YoY (%) 8.2 11.2 20 6.6 6.6 6.6
Date Reported as of September 30, 2022
Source: Bloomberg, Bureau of Labor Statistics and BBH Analysis

Performance and Positioning

Our TIPS portfolios outperformed their benchmarks by 15 basis points last quarter, extending year-to-date outperformance to 25 basis points. Our strategies based on seasonal patterns, term structure positioning, and TIPS auction cycle contributed to outperformance. Similarly, our breakeven position in accounts with futures authority contributed to outperformance. Motivated by Fed tightening, we kept our term structure allocation slightly behind the benchmark in terms of duration, and added a flattening bias expressed in the intermediate-to-long parts of the real yield curve. Following the selloff in real yields by the end of Q3 and the subsequent underperformance of TIPS relative to nominal Treasuries, valuations became more favorable, and we positioned our portfolios with a slight overweight.

The Great Tightening

The Fed is increasing rates at the most aggressive pace since the era of interest rate targeting began in late-1987. Since then, the Federal Open Market Committee (FOMC) raised the policy rate in 45 meetings (see Exhibit II). The FOMC increased the funds rate by 75 basis points only four times, once in 1994, and three times in the current cycle. Although the funds rate increased 425 basis points between 2004 and 2006, it occurred at a pace of about 18 basis points per month. This year, the Fed increased the policy rate 300 basis points since March; a pace of 50 basis points per month. As of September 30th, fed funds futures imply the FOMC will deliver a fourth consecutive 75-basis points increase in November, and a 50-basis points increase in December, leaving the fed funds rate at 4.5% by year end.
 

Exhibit II: Fed Tightening Cycles in the last 30 Years

Cycle First Hike Last Hike No. Months No. 25bps A+ No. 50bps A+ No. 75bps A+ Total Increase (Bps)
1994-1995 2/4/1994 2/1/1995 12 3 3 1 300
1997-1997 3/25/1997 3/25/1997   1     25
1999-2000 6/30/1999 5/16/2000 11 5 1   175
2004-2006 6/30/2004 6/29/2006 24 17     425
2015-2018* 12/17/2015 12/20/2018 21 9     225
2022 3/17/2022 9/22/2022 6 1 1 3 300
        36 5 4  
(*) Since the Fed paused for a year after one hike in December 2015, and for 14 months after one hike in December 2016, we combined all hikes into one cycle.
Source: Board of Governors of the Federal Reserve System and BBH analysis.

In addition to normalizing rate levels, the Great Tightening is normalizing interest rate volatility. Consider the daily changes of the 2-year nominal Treasury rate since 1987 (see Exhibit III). The red lines enclose the range containing 90% of daily fluctuations in three distinct periods. Until the GFC, 90% of daily fluctuations remained within -10 and 10 basis points. The width of the 90%-interval compressed to -5 to 5 basis points from 2010 until 2021, when the Fed kept the funds rate at the zero lower bound. The most recent 90% interval, after November 2021, resembles the pre-GFC period, with daily changes between -10 and 13 basis points (a bit biased upward given Fed tightening). The rate normalization process has devastated markets this year, but it is also bringing back opportunities that had been suppressed by Fed policy for over a decade.


Exhibit III: The graph shows daily fluctuations going back to late 1987. Before the Global Financial Crisis, 90% of daily changes in the 2-year rate stayed with -10 and 10, this 90% interval compressed to between -5 and 5 basis points until November 2021. Since then, daily rate fluctuations have been between -10 and 13 basis points.

Is The Great Tightening Working?

Inflation is a process, and so is disinflation. In that sense, it is too soon to assess the impact of ongoing monetary policy. Markets on the other hand, express their views immediately. Medium- and long-term market-implied inflation expectations remained anchored throughout the inflationary process, staying within a reasonable range of the 2% target. That is a huge vote of confidence in the Fed’s ability to bring back price stability. By the end of Q3, even energy-sensitive short-maturity breakevens hovered around 2% (see Exhibit IV).


The graph contrasts market-implied inflation expectations (breakevens) and actual underlying inflation. Breakevens have remained below 3% almost all the time, even though underlying inflation exceeded 6%.

In terms of actual inflation, goods prices have calmed down, largely because as the economy returned to its pre-COVID dynamism, consumption shifted to services. Additionally, price pressures from disrupted supply chains have eased, and a strong U.S. dollar makes imports cheaper. Services have been driving underlying inflation. Shelter, or rent inflation, accounts for 40% of core Consumer Price Index (CPI) and has kept core inflation running strong (see Exhibit V). We think this could continue for longer. Alternative indicators of rent inflation, such as Zillow’s rent index have already slowed down, but this indicator leads shelter by several months; therefore, we would not expect shelter to ease any time soon (see Exhibit VI).


The graph shows the composition of core monthly inflation. Over the last few months, monthly inflation has been driven by services, especially rent inflation.

 


The graph shows that the Zillow rent index leads CPI shelter inflation by six about months, indicating that CPI shelter is likely to remain strong for a while.

 

Financial conditions have tightened to restrictive levels, with mortgage rates close to 7% and equity market losses driving negative wealth effects. Yet, the Fed remains confident they will attain an immaculate disinflation. Their Summary of Economic Projections shows inflation within 2% by 2024 at an unemployment rate only 1% higher than the current level. The Fed’s confidence rests on the notion that job openings have reached historical highs. Therefore, as financial conditions restrict economic activity, job openings will fall, easing wage pressures as unemployment rises. Since their peak in March, job openings have fallen by 1.8 million, wage growth has stayed flat at 6.7% since June, and unemployment moved only a little around 3.5%. The job market may be approaching a turning point, but for now it remains a source of inflationary pressure and will not deter the Fed from keeping financial conditions restrictive for longer.

Conclusion

The Fed will stay hawkish, operating with a singular-mandate mindset of price stability. But preserving maximum employment is a policy principle too, and eventually the trade-off will change. Although futures markets expect the Fed might pause around May 2023, we do not know for certain when this will happen, and there is much uncertainty around the path ahead for interest rates and inflation. Market-implied inflation expectations near 2%, underlying inflation over 6%, and likely to stay elevated for longer, present very attractive opportunities to acquire inflation protection. We think this provides opportunities for investors to create or add allocations to TIPS.

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

Jorge G. Aseff, PhD
Portfolio Co-Manager

Performance As of September 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)

-4.98%

-13.42%

-11.43%

0.74%

1.95%

1.10%

5.12%

BBH Inflation-Indexed
Fixed Income Composite (Net of Fees)

-5.02%

-13.52%

-11.57%

0.59%

1.79%

0.95%

4.96%

Bloomberg U.S. TIPS Index

-5.14%

-13.61%

-11.57%

0.79%

1.95%

0.98%

4.76%

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

Past performance does not guarantee future results.
 

1 A unit that is equal to 1/100th of 1% and is used to denote the change in 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. 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 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.

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. 2022. All rights reserved.

IM-11883-2022-10-24    Exp. Date 1/31/2023

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