BBH Inflation-Indexed Fixed Income Quarterly Update

BBH Inflation-Indexed Fixed Income Quarterly Update – 1Q 2024

March 31, 2024

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.

Q1 Highlights

In Q1 2024, financial conditions continued to ease. Labor markets performed better than expected and inflation surprised on the upside. As a result, the higher-for-longer narrative returned.
Higher uncertainty about near-term inflation creates a favorable environment for TIPS that may extend their outperformance over nominal Treasuries a little longer.

Higher for Longer… Again

The steep decline in interest rates last quarter culminated in a dovish shift by the Federal Reserve (Fed). Yet, this quarter investors are once again contemplating higher rates for longer. During the quarter, easier financial conditions boosted economic performance, leading labor markets and inflation to surprise on the upside. The shift in narrative is best illustrated in the market for Federal Funds futures. At the end of 2023, futures priced 160 basis points¹ in policy rate cuts before the end of 2024, beginning as early as March. By quarter end, only 70 basis points in cuts are priced, beginning in July.

In inflation markets, the 10-year real rate increased 17 basis points (see Exhibit I). Moreover, above-consensus inflation led market-implied inflation expectations (breakevens) to increase. Breakeven inflation rates at the 10-year maturity point increased 15 basis points. For the quarter, Treasury Inflation-Protected Securities (TIPS) returned -8 basis points, outperforming similar-maturity nominal Treasuries by 88 basis points.

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Exhibit I: A table displaying real yields and breakevens at 5, 10, and 30 year intervals for inflation-indexed markets as of March 31, 2024.

Portfolio Positioning and Performance

The Fed’s tightening cycle severely inverted the real yield curve, a shape that tends to revert as the policy cycle matures. Our valuations found return potential in curve normalization, and we positioned the TIPS portfolios accordingly. To implement our active strategies, we tend to use 10-15 securities out of dozens that constitute the Bloomberg U.S. Treasury Inflation-Linked Bond Index (the TIPS index). Most of the securities in our TIPS portfolios are in the short-to-intermediate parts of the curve, with a handful concentrated among long maturities. The resulting term structure favored the short- and long-parts of the real yield curve over the middle (see Exhibit II).

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Exhibit II: A graph displaying TIPS term structure allocation as of March 31, 2024, where the portfolio favors the short- and long-parts of the real yield curve.

Our TIPS portfolios outperformed their benchmarks by 10 basis points at quarter-end. The slight overweight in duration detracted some performance. In addition, the TIPS Index extended in February by more than one-third of a year, as two securities maturing in January 2025 were replaced by a 10-year bond maturing in January 2034. This index extension, the longest since 2009, benefitted our portfolios as we increased duration in advance of index rebalancing at the end of January 2024.

The Economy and Inflation

The tightening of financial conditions triggered by Fed’s tightening cycle peaked in late 2022 (see Exhibit III). A series of expansionary fiscal policies, strong household finances, and rising equity prices eased financial conditions to the point that current levels reflect tailwinds to economic growth. This easing has had a strong impact on economic performance. In Q4, the economy expanded at an annualized rate of 3.4%, and according to real-time estimates such as those published by the Atlanta Fed, growth reached 2.8% in Q1. Furthermore, in March, the Fed’s Summary of Economic Projections increased projected real economic growth for 2024 from 1.4% to 2.1%. In hindsight, it was premature to expect several rate cuts in 2024.

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Exhibit III: A chart displaying financial conditions as of March 31, 2024, where conditions remained tight for most of 2023 and eased towards year-end.

The labor market added 830,000 jobs during the quarter, and the unemployment rate has not been above 4% in more than 2 years. Additionally, wage growth, measured by the Atlanta Fed, is 4.7%, the first time it dropped below 5% since December 2021. In this macroeconomic context, it is not surprising that the Fed is struggling to bring inflation back to its 2% target.

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Exhibit IV: A table showing inflation rates as of March 31, 2024 where the 3-month annualized inflation rate is 1% above the annual rate.

On a year-over-year basis, Consumer Price Index (CPI) inflation remained between 3.5% and 4.0% during the quarter. Month-over-month data show headline and core inflation accelerated. Exhibit IV above shows the 3-month annualized inflation rate is 1% above the annual rate. Higher energy prices increased headline CPI inflation while the services sector drove core CPI inflation higher. In the last three months, shelter inflation fluctuated between 0.4% and 0.6%, about twice its pre-2020 average of 0.24%. Since shelter represents more than 40% of core CPI, it remains the largest contributor. Services excluding housing, also known as supercore, represents 30% of core CPI but contributed at par with shelter in recent months. The transportation sector contributed the most to higher prices in supercore services (see Exhibit V). In terms of Personal Consumer Expenditure (PCE), the Fed’s preferred inflation measure, the increase was more moderate than with CPI, mainly because the housing sector constitutes a smaller share of the PCE index.

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Exhibit V: A graph showing contributions to monthly Core CPI inflation as of March 31, 2024, where the transportation sector contributed the most to higher prices in supercore services.

In Q1 2024, labor markets performed better than expected and inflation surprised on the upside three consecutive times. As a result, the higher-for-longer narrative returned. Time will tell whether higher inflation is a bump on the road to 2% or something more persistent. While the economy marches at the current rhythm, it will be difficult to see a meaningful decline in inflation, let alone a Fed cut. Higher uncertainty about near-term inflation creates a favorable environment for TIPS that may extend their outperformance over nominal Treasuries a little longer. It is a good time to add to TIPS allocations.

Performance As of March 31, 2024
Composite/Benchmark	3 Mo.	YTD	1 Yr.	3 Yr.	5 Yr.	10 Yr.	Since Inception
BBH Inflation-Indexed Fixed Income Composite (Gross of Fees)	0.02%	0.02%	0.13%	-0.63%	2.45%	2.28%	5.04%
BBH Inflation-Indexed Fixed Income Composite (Net of Fees)	0.02%	-0.02%	-0.02%	-0.78%	2.30%	2.12%	4.88%
Bloomberg U.S. TIPS Index	-0.08%	-0.08%	0.46%	-0.53%	2.49%	2.21%	4.71%

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.

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. 2024. All rights reserved.

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IM-14478-2024-04-17 Exp. Date 07/31/2024