Are You Ready for Higher Inflation?

For most of the last 20 years, advisors could safely ignore inflation and the risks it posed to their clients’ fixed-income holdings and earning power. But inflation is too dangerous a risk to disregard. What are the chances of an upward spike in inflation and what would that mean for clients?

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On September 19, I was at Vanguard’s headquarters in Malvern, PA, and explored that question in an interview with Anne Mathias, the senior global rates and fixed-income strategist on its active fixed income team.

For the seven years prior to the financial crisis, the personal consumption expenditure (PCE) price index was mostly between 2% and 2.5%. Since 2008, it has been consistently below 2%. The PCE is the Fed’s preferred measure of inflation and 2% is its inflation target.

Indeed, since the financial crisis, the Fed has been more concerned about deflation than inflation. An upward-sloping yield curve signifies that the market expects inflation. As Mathias said, the premium between two- and 10-year yields is a measure of inflation expectations. The Fed has reacted quickly to episodes of an inverted yield curve, as it did over the summer by lowering short-term rates.

But, as Mathias told me, “inflation may be forgotten, but it is not gone.”

What drives inflation?

Vanguard’s has shown that forces such as globalization and technological innovation have been tempering inflation on a secular, long-term basis. In addition, as the U.S. has transitioned from a manufacturing- to a service-based economy, technology has made supply chains and the delivery of goods much more efficient. That reduces the possibility of inflation coming from a shortage of goods, because supply is efficiently and quickly responsive to spikes in demand.

But over shorter, cyclical time frames, other dynamics are at play.

Mathias warned that, with unemployment at a historically low level, wage pressure could lead to inflation. According to the Phillips curve theory, all else equal, when unemployment gets low enough, companies start to bid up the price of labor. A “virtuous” cycle could develop, she said, where growing wages would support consumption, fueling economic growth leading to higher inflation.

“That’s one of the things that is happening,” Mathias said.

She is also concerned about inflation coming from the U.S.-China trade dispute. A number of companies are paying 10% to 20% more for goods produced in China, and eventually those costs will be passed on to consumers.

The Fed, by cutting short-term rates, is trying to create inflation by making money “cheaper,” Mathias said. The problem it faces is that the other major central banks have similar goals and can be more aggressive in their monetary policies, either through rate cuts or quantitative easing (QE).

“It’s a race to the bottom,” she said, “and our Fed has been losing.” For example after the Fed’s most recent cut, on September 18, the dollar strengthened.

A stronger U.S. dollar means that imports should become less expensive. That, in turn, can lead to less demand for American goods and services, which can force U.S. businesses to cut prices to remain competitive, having a deflationary effect. “But that does not mean that we are immune from inflation pressures,” Mathias said.

Helping to protect against inflation

Treasury inflation-protected securities (TIPS) are the purest form of hedging inflation, and Mathias said they are attractively priced.

The implied inflation rate, based on five-year TIPS, is approximately 1.35%. But Vanguard’s economics team – as well as the Wall Street Journal’s survey of other economists – expects inflation to be closer to 2% over the next few years.

“Even the Fed thinks inflation will get to 2% in the 2021 time frame,” Mathias said.

Investors in TIPS benefit to the extent that actual inflation is higher than the implied rate of inflation when they bought the bond.

Overall, Mathias said, the market is pricing inflation “attractively,” creating opportunities for the active bond funds she advises. She spoke with her colleague, Gemma Wright-Casparius, who manages Vanguard’s active Inflation-Protected Securities Fund (VAIPX). For those of us who have grown up with a Fed that is poised to fight inflation, the idea that the Fed would foster inflation is new. But, Wright-Casparius pointed out that the Fed actually wants inflation to rise a bit more. If low interest rates or a possible fiscal stimulus over the next couple of years cause inflation to rise, the Fed will be unlikely to stop it with rate hikes.

Wright-Casparius said, “Since inflation has been below the Fed’s target [of 2%] for the past 10 years, the Fed is willing to let inflation run above that target for a period of time.”

Both short- and longer-term TIPS, as well as short-term corporate bonds can offer inflation protection, Mathias said. She spoke with Arvind Narayanan, a credit portfolio manager, who said that short-duration corporate bonds can provide good income and are a better inflation hedge than longer duration bonds.

The key reason for owning corporate bonds is that, if inflation is driven by a strong economy, purchasing power will be growing, consumption will be increasing, profits will be strong and the risk of default low, according to Mathias.

Read the full article here by Robert Huebscher, Advisor Perspectives

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