High inflation has been front and centre with the U.S. Consumer Price Index (CPI) reaching 6.2% year over year in October and 0.9% month over month with both figures ahead of forecasts. These are big numbers not seen in more than 30 years.
Higher prices are now topical for everyone—not just for investment professionals—now that every trip to the gas pump, supermarket, or sporting goods store is a potentially disheartening experience for those on fixed salaries (i.e., most working people). This discontent is bubbling upward; recently inflation was cited as the major factor behind Joe Biden’s approval rating plunging to 42% from 54% back in June 2021 (source: Real Clear Politics).
Why Covid Is Not Solely to Blame
So, what’s the cause of this inflation? Overall, the fixed-income team at Purpose Investments views today’s inflation as a function of more than just Covid, logistics, weather, and ESG investing-induced supply constraints.
We also believe the historical 36% cumulative growth in M2 U.S. money supply since February 2020 is a causal factor that normally affects overall price levels with a varying lag of one to three years. A list of anecdotes surrounding sky-high prices involving goods, services, and asset bubbles caused by too much money sloshing around could be a question on Family Feud.
Inflationistas No More
If you’ve never heard the term, an “inflationista” is someone skeptical when the government pumps too much money into the markets, worrying it will eventually result in runaway inflation.
Although we started 2021 in the inflationista camp, now that (1) the bad news seems to be out in the open and that (2) the worst of the “base effect” lapping of Covid-depressed pricing levels for major commodities (e.g., corn, iron, and ore) and other industrial inputs is coming to an end, we have become more pragmatic in our views.
The Risk and Reward of Fixed Income
While the worst of the inflation problem may be at hand this Christmas season, it doesn’t mean it’s safe to go back in the traditional fixed-income water. It’s not about the forecast—it’s about risk and reward.
What matters for traditional fixed income is that the U.S. 10-year bond yield is still just 1.56%, which is a fraction of all of CPI. As indicated in the chart below, Producer Price Indexes (PPI) and five-year and ten-year break-even rates discounted in inflation-protected securities still seem distorted in light of historical fair value for bond yields that are normally higher than the inflation rate. This value dislocation is persistent on the cusp of the U.S. Federal Reserve completely withdrawing support for the bond market (i.e., quantitative easing) in the next year.
Virtually every traditional billion-dollar bond fund we track has lost money in 2021 to date and yet bond yields for government and investment-grade corporate debt are still close to all-time low levels while duration (interest rate risk) is close to all-time highs. For those investors that are “long” in these funds, collectively their net internal yield (after expenses) is still under 1%.
According to our research, a 100 basis point move in bond yields the wrong way, which is relatively insignificant historically, could potentially wipe out 10 years of income in these funds. We will continue to take the other side of the trade and short the “no reward risk” in our alternative fixed-income strategy as an inexpensive hedge to a variety of potential calamities.
The Performance of Risk Assets
In the face of sustained inflation, risk assets have performed well since the September swoon with the S&P 500 and TSX/S&P composite reaching new highs in recent days. We attribute the positive performance to corporate earnings growth and an earnings outlook that incorporates revenue growth bolstered by inflation. Revenue and earnings are nominal and not inflation adjusted.
According to Bloomberg, estimated 2021 U.S. Real GDP growth peaked in May/June at 6.5% and has since declined to 5.5%. However, nominal GDP forecasts for the year 2021 have remained in the 10% area because estimates for CPI increased. And 10% is a big number.
We continue to view the business cycle outlook as constructive from here for high-yielding corporate debt, since the cycle is still in early innings and corporate debt default rates are continuing to decline. The odds of a recession in the next 12 to 18 months are low, in our view.
While this business cycle may not be as long as 10-11 years like the last one, we think there is plenty of room for growth from here given pent-up demand, record personal income, and the wealth effect of asset appreciation to name a few factors.
— Sandy Liang, CFA, is the Head of Fixed Income and Partner of Purpose Investment Partners
All data sourced to Bloomberg unless otherwise noted.
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