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Steve Lowe, CFA
Chief Investment Strategist

MARKET UPDATE

Inflation & bond market dynamics

05/25/2021
By Steve Lowe, CFA, Chief Investment Strategist | 05/25/2021

Inflation that gripped the economy in the 1970’s and early 1980’s had such debilitating consequences for financial markets, that economists and investors have ever since kept a watchful and anxious eye on the possibility of a return to that challenging environment.

It has been nearly a 40-year unfulfilled vigil.  However, recent developments in the economy and markets are now flashing warning signs about the prospect of a return to some higher levels of inflation.  How serious are these warnings signs, and how should investors factor that prospect into managing their portfolios?

Warning signs

Inflation statistics at both the producer and consumer level just vaulted to levels not seen in nearly 10 years. The most recent monthly Consumer Price Index reading shows inflation running at a level of 4.2% on an annualized basis, with the most recent Producer Price Index running even higher at 6.2%.  It is important to note that these unsettling statistics are heavily influenced by “base effects,” which means they show a somewhat distorted near-term picture when compared with last year because of the extremely low “base” inflation numbers from a year ago when prices were falling sharply in the early stages of the pandemic.

The bond market has been factoring in the possibility of higher inflation for a number of months.  Long term interest rates have increased by 75 basis points (0.75%), the yield curve is steepening (long maturity yields moving up much more than short maturity yields), and Treasury Inflation Protected Securities (TIPS), which are indexed to inflation, have massively outperformed conventional coupon treasury securities.

Commodity prices have been surging across the board.  Oil is up over 35% since the beginning of the year, while copper and lumber are up 40% and 95% respectively over the same time frame.  Interestingly, in a significant departure from historical precedent, gold, considered to be a solid hedge against inflation over millennia, has declined 5% year to date!  However, Bitcoin, which in some investor’s minds has become the new “digital gold,” has seen tremendous – although volatile – growth in recent years.

Paying heed to warning signs

The fundamental force behind these warning signs is the massive amount of monetary and fiscal stimulus, the likes of which the U.S. economy has never seen. Trillions of dollars have been pumped into the system to support consumer demand for goods and services in response to the pandemic.

Meanwhile the pandemic has seriously disrupted the supply of goods and services. Simple economics dictates that when demand outstrips supply, prices will rise. The Federal Reserve (Fed) and other policy experts assert these inflationary impulses will be “transitory” and short-term in nature.  Investors should be very circumspect, if not outright skeptical about this perspective. Consumers also appear concerned, with consumer sentiment declining as inflation fears mount.

Certainly, the current environment is unusual given the pandemic. Commodity prices may retreat as economies normalize and pandemic-related supply chain problems become resolved. However, some of these impacts may be long-term in nature.  Serious questions have arisen regarding the risk and economic benefits of significantly outsourcing supplies and/or production to “cheaper” countries.

Furthermore, negative political dimensions have become evident as domestic companies assess the risk of foreign governments impacting their supply chains or production processes. These risks were percolating in the “tariff wars” that preceded the disruptive force of COVID-19.

Inflation targeting has proven to be problematic for the Fed, which for the past decade has been unable to consistently boost inflation to its 2% target, missing more than 90% of the time. Now the Fed may be overestimating its ability to precisely engineer and control inflation, particularly given the unprecedented magnitude of the accommodative monetary policy they have been following for many years. Inflation tends to remain subdued until it isn’t, and then it can become non-linear, as inflationary expectations become rooted in the minds and actions of consumers and businesses.

The economy has shown dramatic strength as it moves to “reopen.”  Longer term, the main concern is less about commodities, supply bottlenecks or even a spike in demand; it is wages and a tight labor market.  Although more than 8 million people remain unemployed, there is now a record number of over 8.1 million jobs that remain unfilled.

Although anecdotal, there are widespread stories of businesses, especially in the service industries, that are challenged in their efforts to reopen given the dearth of respondents for job openings.  Furthermore, there is evidence of businesses finally “opening their wallets” by offering higher wages to attract employees.  Companies such as McDonalds, Amazon and Chipotle have announced significant increases in average hourly wages, as well as signing bonuses to attract and retain labor. Clearly higher wages are good for the US economy. However, this will contribute to additional inflationary pressures.

Bond Market Implications

Inflation remains the biggest threat to investment portfolios, especially bond portfolios. However, it seems unlikely that inflation will come anywhere near the inflationary environment of the 1970’s.  That era was vastly different in that inflation was driven by an oil price shock that affected an economy that was much more dependent on energy.

A wage-price upward spiral also took hold with cost-of-living wage adjustments commonplace. While a return to the 1970’s inflationary environment is unlikely, even modest increases in interest rates will continue to negatively impact longer duration bonds.  It is advisable that investors remain defensive with their bond portfolios from an interest rate risk perspective. This implies focusing on floating rate and/or shorter maturity bond exposure.

It also implies looking for diversification and incremental yield from multiple sectors of the market. This includes some selective exposure to preferred stocks, leveraged loans, low duration mortgage-backed securities, high yield and emerging market bonds.

For high tax individuals, municipal bonds may still make sense, especially if the current administration is successful in enacting legislation that leads to higher tax rates. Finally, with yields remaining historically low across all sectors of the fixed income market, return expectations should be low as well. Although returns will be low, fixed income remains an important diversifying element in an overall portfolio construction.

 


All information and representations herein are as of 05/25/2021, unless otherwise noted.

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.