Inflation-Indexed Fixed Income Quarterly Update Q4 2020

December 31, 2020
Portfolio Manager, James Evans, provides an analysis of the investment environment and most recent quarter-end results of the Inflation-Indexed Fixed Income strategy.

Downs and Ups

Beginning a new year is an opportunity to look back, reflect on the year behind us, and turn to the year ahead. Last year, when almost everything that keeps us up went straight down, we were tested as individuals, as a society, and as professionals. We realized that we can work effectively together, even when separated. We saw in 2020 that our institutions can be swift and aggressive to contain a crisis. Our doctors and first responders worked tirelessly to save lives – here in New York, it felt great to join everyone to thank them in unison every evening at 7 pm. And our scientists developed a vaccine that is now being distributed. Thanks to all of them, we finally see a glimmer of hope.

Markets

Unprecedented fiscal and monetary stimulus helped financial markets rebound from their March lows. For the year, equity markets returned 18%, a remarkable result considering they were down 33% between February 21st and March 23rd. After tightening more than 280 basis points1 in the last three quarters, investment-grade corporate spreads returned to their pre-COVID levels by the end of the year, generating 9.9% returns for the year. Market-implied breakeven rates of inflation (breakevens) had an impressive run as well. After dropping more than 80 basis points to 0.5% in Q1, the 10-year rate closed 2020 at 2%, a level last seen in 2018.


Quarterly Change in 10-Year Breakeven Inflation Rates: The 10-year rate fell in 86 basis points in Q1; and it increased 41, 29, and 35 basis points in Q2, Q3, and Q4, respectively.

Change in Real Yields and Breakevens: Change in real yields and breakeven inflation rates in Q4 2020 and YTD. Short-maturity yields fell the most. In breakeven space, short rates increased the most, showing TIPS outperformed nominal Treasuries.
Change in Real Yields and Breakevens
Change
Real Yields (bps) Breakevens (bps)
  5 Yr 10 Yr
30 Yr 5 Yr 10 Yr 30 Yr
QTD -38 -14
-4 47
35
23
YTD
-162 -122 -95 27 20 19
Data reported as of December 31, 2020
Sources: Bloomberg and BBH Analysis

Last year, real yields rallied 125, 110, and 90 basis points at the 5-, 10- and 30-year maturities, respectively. Overall, TIPS returned 11% in 2020, outperforming nominal Treasuries by 1.4% on a duration-adjusted basis, another outstanding recovery given that they lagged by almost 9% in Q1-2020. As TIPS returns improved, flows into TIPS-related exchange traded funds (ETFs) strengthened, netting over $12 billion in 2020 on a cumulative basis, a reversal from a cumulative net outflow of $4 billion reached in April.

Performance

In the fourth quarter, our full-maturity TIPS portfolios returned about 1.5%, bringing the annual absolute return close to 11%. An important factor underlying our investment decision is seasonality in the TIPS market. In the first half of the year, the real yield curve tends to steepen, and then flattens as we enter the second half. This year, the seasonal patterns were disrupted, and although in Q4 we positioned our portfolios for a steeper curve, the duration underweight in the long-maturity part of the curve shortened overall duration, causing relative performance to trail as real yields rallied.


Real GDP and Unemployment Rate: Real GDP growth and unemployment (inverted scale on the right) shown from 2015 Q1 to 2020 Q3. Both illustrate the rebound of economic activity in 2020 Q3.

The Economy

Before COVID, the economy was marking the longest expansion on record – uninterrupted gross domestic product (GDP) growth for 128 months. Then, following a deliberate decision to shut down the economy in order to contain a health crisis and save lives, real GDP collapsed 31% in Q2. The unemployment rate, which had reached a 50-year low in February, jumped to 14.8% in April. The policy response was impressive, the Federal Reserve (Fed) expanded its balance sheet by $3 trillion, and the Senate passed the $2.2 trillion Coronavirus Aid, Relief and Economic Security (CARES) Act, currently exceeding $3 trillion.

As the economy reopened and income remediation policies took effect, the economy bounced back in Q3 at an annual rate of 33%, closing about 65% of the collapse from Q4 2019 to Q2 2020. Today, the unemployment rate is at 6.7%, more than 8% below the COVID peak. Our preferred measure of general economic activity, the 3-month moving average of the Chicago Fed National Economic Activity Index (CFNAI), reached -7 in April, recovering to above 4 by the end of July, and settling around 0.56 in November.2

When thinking about the path ahead for the economy, it is tempting to look at the path which followed the Global Financial Crisis (GFC). In our view, post-COVID is not post-GFC. For instance, unlike the post-GFC period, policy coordination this time around will persist and perhaps strengthen. There is a sense among economists that the fiscal tightening in the years following the GFC slowed growth rates during the expansion. This time, with unemployment at 6.7% and increasing pressures to address income inequality, neither the Fed nor the Treasury will want to tighten too soon. The banking system is well-capitalized and will not prevent the transmission of monetary policy from working. Consumers, willing but unable to spend in lockdown, are not deleveraging; in fact, they are in much better shape with equity and housing prices on the rise.


Chicago Fed National Activity Index - Three-month Moving Average: A measure of aggregate economic activity updated monthly. A values below -0.7 following an expansion indicates a high likelihood of recession. The lowest point in the GFC was around -3; after COVID-induced shutdowns, this index dropped under -7 and bounced back to 4 as the economy reopened.

Inflation

From January to May, annual headline consumer price index (CPI) and core CPI fell from 2.5% and 2.3% to 0.1% and 1.2%, respectively. In March, April, and May consumer prices experienced monthly negative changes. In fact, core CPI’s print in April was the worst monthly decline on record. Today, with headline CPI at 1.4% and core CPI at 1.6%, there are good reasons to expect higher levels ahead. One reason is more technical. In 2021, the March-to-May negative prints just mentioned will fall off the 12-month rolling index calculation. At current trends, this base effect could push CPI above 3%.

Other reasons are more fundamental. There are fiscal policies in place financing wage subsidies and enhanced unemployment benefits. Furthermore, the Democratic victories in Georgia’s Senate special election will make the incoming administration’s objectives to enhance fiscal policy and reduce income inequality a little bit easier to accomplish. Although the federal budget deficit is 15% of GDP and public debt is above $21 trillion, there is today a more tolerant view of debt-financed government spending, especially when the Fed’s timeline to raise rates suggests rates will remain low for the next two or three years.

Second, monetary policy will remain accommodative even if inflation accelerates. On one hand, it is still early in the recovery and risks of a prolonged or worsening public health emergency are still present. On the other hand, after several years of subdued inflation, the Fed needs inflation to run above 2% for a couple of years in order to bring its average near 2%, as directed by their Average Inflation Targeting framework.
Third, the strength of the private sector and the retreat of globalization can push prices up. Strong returns on assets and high savings rates could easily unleash consumption and fuel pent-up demand. Businesses need to mitigate risks of disruption embedded in global supply chains, subjecting cost minimization strategies to tighter constraints; i.e., domestic input markets and stricter health and safety guidelines. This will result in more expensive goods.

Conclusion

COVID-19 continues to spread throughout the world and we still feel anxious about the uncertainty the pandemic added to our lives. But the development and distribution of vaccines injected a much-needed doses of optimism. Looking ahead, we see strong potential for inflation to accelerate within a context of an inflation-tolerant, if not nurturing, policy environment. Breakeven inflation rates reflect similar views from investors and recovered strongly last year, setting a positive trend that remains strong going into the new year. As always, we will be ready to benefit from new opportunities with our time-tested investment strategies and disciplined investment process. Happy and healthy 2021!

Sincerely,
James J. Evans, CFA
Portfolio Co-Manager
    
Jorge G. Aseff, PhD
Head of Quantitative Research

BBH Inflation-Indexed Fixed Income Composite Performance as of December 31, 2020 versus the Bloomberg Barclays US TIPS Index.
Performance
As of December 31, 2020
  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) 1.33% 10.73% 10.73% 5.86% 5.12% 4.02% 5.89%
BBH Inflation-Indexed Fixed Income Composite (Net of Fees) 1.29% 10.57% 10.57% 5.70% 4.96% 3.86% 5.73%
Bloomberg Barclays U.S. TIPS Index 1.62% 10.99% 10.99% 5.92% 5.08% 3.81% 5.51%
* Returns are not annualized.
Sources: BBH & Co. and Bloomberg
Past performance does not guarantee future results.

The Strategy was previously called the BBH Inflation-Indexed Securities Strategy.
1 Basis point (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in price or yield of a financial instrument.
2 For reference, a value below -0.7 indicates a recession, and a value above 1 following an economic expansion denotes an inflationary period.

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 Composite is comprised of 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. On 10/1/2020 the BBH Inflation-Indexed Securities Composite was renamed the BBH Inflation-Indexed Fixed Income Composite. Accounts are benchmarked to the Bloomberg Barclays U.S. TIPS Index or equivalent.

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-08962-2021-01-22    Exp. Date  04/30/2021

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