BBH Inflation-Indexed Fixed Income Quarterly Strategy Update

BBH Inflation-Indexed Fixed Income Quarterly Strategy Update – 3Q 2023

September 30, 2023

James Evans
Jorge Aseff

Investment Management

Portfolio 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

Investors assign a 50% probability of a final hike by December 2023, but how long will short rates stay at restrictive levels?
Inflation has moderated, labor markets continue to gradually cool off, and the end of the Federal Reserve’s great tightening seems near.
Annual headline Consumer Price Index inflation reached 3.7% in Q3, driven by higher energy prices. Core CPI inflation has been more persistent and is at 4.3% on an annual basis.

How Long?

We have always liked characterizing the Federal Reserve’s (Fed) tightening program with the following three questions: (1) How high will rates get? (2) How fast will they increase? (3) How long will rates stay elevated? Since March 2022, the Fed has delivered 525 basis points¹ in policy rate hikes, including four consecutive 75-basis point hikes. Today, investors assign a 50% probability of a final 25-basis point hike by the end of the year. The end of the tightening cycle is palpable, but how long will short rates stay at restrictive levels? Interest rates tend to stabilize near the end of a monetary policy cycle, and often begin to drift lower. Not this quarter.

During the quarter, the 10-year nominal Treasury yield climbed 70 basis points, lifting the term premium 30 basis points. In inflation markets, 10-year real yields increased 60 basis points, reaching 2.25% for the first time since 2009 (see Exhibit I). As a result, the Treasury Inflation Protected Securities (TIPS) index fell 2.6% in the quarter, bringing its year-to-date return to -0.78%.

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Exhibit I: A table displaying real yields and breakevens at 2, 5, 10, and 30 year internals for inflation-indexed markets as of September 30, 2023.

By comparison, market-implied inflation expectations (breakevens) had a quiet quarter. The 5-year breakeven inflation rate increased 5 basis points, and the 5-year breakeven rate, 5 years forward, increased 20 basis points. For a change, investors’ inflation expectations increased more in longer tenors.

Performance and Positioning

The steep selloff in rates late in the quarter detracted from performance and our TIPS portfolios underperformed their benchmarks. Our allocation across the real term structure benefited from the real yield curve steepening, but it was not enough to offset the negative impact of rising rates on our slight duration overweight. A position in nominal Treasuries also added to performance late in the quarter.

Inflation and the Fed

Driven by higher energy prices, annual headline Consumer Price Index (CPI) inflation increased to 3.7% in Q3 (see Exhibit II). Core CPI inflation has been more persistent and is at 4.3% on an annual basis. The Fed’s preferred measure of inflation, the Personal Consumer Expenditures excluding food and energy (core PCE), dipped below 4% for the first time since June 2021.

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Exhibit II: A line graph displaying headline and core CPI inflation from January 2020 through August 2023 where headline CPI inflation falls faster than core CPI inflation.

Housing inflation, or shelter, accelerated in September. Housing’s annualized quarterly inflation rate is 5.6%, far below its Q1 peak, but about twice its pre-pandemic average. Inflation in the services sector excluding housing, or supercore inflation, increased consistently in Q3 to an annualized rate of 4.7%. The Fed follows this sector closely given its strong link to the labor market.

Although nonfarm payroll employment surprised investors in September by adding 336,000 jobs, the labor market has been on a moderating trend (see Exhibit III). Currently, the 12-month average nonfarm payroll is 140,000 jobs lower than it was at the beginning of this year. Labor costs have receded as well, with overall wage growth falling to 5.3%, and the gap between job switchers and job stayers has almost disappeared, compared to its record-wide level a year ago².

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Exhibit III: A graph displaying wage growth as of August 31, 2023, where the labor market has been moderating its pace.

Core inflation persists around 4%, a much more moderate level than a year ago, but it is still too high for the Fed’s comfort. There has been progress in labor markets, but data surprises and revisions make it difficult to assert with confidence that inflation is convincingly trending toward 2%, as the Fed would want.

As we enter Q4, investors see a 50% probability of a final rate hike in 2023. This deep into a tightening cycle, rates tend to stabilize or begin to decline. Note in Exhibit IV that, unlike in the prior three tightening cycles, the 10-year real rate surged 100 basis points since the July 26^th Fed meeting, while it fell soon after each of the previous cycle ends (the 10-year nominal yield shows a similar pattern). We know longer-maturity rates do not respond in unison to Fed policy expectations and the latest move is unusual. In trying to explain why have rates risen so much, possible explanations are the strength of the U. S. economy continues to surprise; massive Treasury issuance amid deteriorating U.S. fiscal conditions; and falling foreign demand for Treasuries (e.g., China has sold $45 billion since April 2023). We cannot assign relative importance to these factors, but the impact of fiscal conditions could weigh more now than in the past. The last time 10-year nominal Treasuries were at 4.6%, the U.S. debt-to-Gross Domestic Product ratio was 60%, today it is 120%.

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Exhibit IV: A chart showing Federal Reserve rate increases as of September 30, 2023, where the 10-year real yield shot up 100 basis points since the July 26 hike, while it fell soon after each of the previous cycle ends.

Conclusion

How long is now the important question in the trilogy above. We trust the Fed’s assertion that the policy rate should remain restrictive for some time, and it seems that investors have heeded this advice. Although it is hard to pinpoint the exact driver of the recent rise in yields, we cannot miss the importance of 10-year TIPS providing more than 2.25% in real income for the first time since 2009. Moreover, inflation has moderated, labor markets continue to slowly cool off, and the end of the Fed’s great tightening is near. History suggests that elevated yields are likely to recede. This is an opportunity for investors to invest or add to their TIPS allocations.

Performance as of September 30, 2023
Composite/Benchmark	3 Mo.	YTD	1 Yr.	3 Yr.	5 Yr.	10 Yr.	Since Inception
BBH Inflation-Indexed Fixed Income Composite (Gross of Fees)	-2.71%	-0.93%	1.04%	-2.09%	2.08%	1.81%	4.96%
BBH Inflation-Indexed Fixed Income Composite (Net of Fees)	-2.75%	-1.04%	0.89%	-2.24%	1.93%	1.65%	4.80%
Bloomberg U.S. TIPS Index	-2.60%	-0.78%	1.25%	-1.98%	2.12%	1.74%	4.62%

Returns of less than one year are not annualized. The Inflation-Indexed Fixed Income Composite inception date is 04/01/1997. Sources: BBH & Co. and S&P Past performance does not guarantee future results.

¹ Basis points (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
² The Federal Reserve Bank of Atlanta tracks the annual growth in wages for workers who stayed in their job, workers who switched jobs, and for the overall sample.

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.

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 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. 2023. All rights reserved.

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IM-13574-2023-10-18 Exp. Date 01/31/2024