U.S. equity markets have teetered back and forth thus far in June, as 10-year bond yields have made a volatile trek lower. This mixed trading led up to and followed a June 16th update in outlook from the Federal Reserve. The Fed now sees an interest rate hike coming a few months sooner than forecasted back in March: late 2022. The tug-of-war between investors this year has been centered around a combination of monetary and fiscal policy uncertainty, inflation trepidation, and the post-COVID economic resurgence.
Without question, the topic most pressing in investor’s minds recently has been inflation. Google searches for inflation peaked the week of May 9th to levels unseen since the inception of the Google data in 2004. Actions seemed to mirror this trend in May with ETF flows into inflation-linked funds jumping about 5% compared to investment-grade corporate bond ETFs that saw outflows of around 4% according to State Street data. Commodity ETFs also attracted investors hoping to hedge inflation worries and perhaps ride the tails of skyrocketing commodity prices. ETF Database shows over $2B of net inflows into commodity ETFs over the last 3 months. Those that invested in time reaped the rewards of sharp price increases, but prices have since begun to settle down. Time will tell if these investments will be needed as an ongoing inflation hedge.
Source: Wall Stree Journal
We are seeing elevated inflation levels. Both CPI and PCE inflation data reached their highest levels in over a decade and over two decades, respectively. These measures are quite different but regardless of the data, consumers and businesses can feel the inflation. The question that financial pundits, the Federal Reserve, and investors alike are trying to answer: are these inflation levels going to be short-lived or are they a longer-term trend? Perhaps the more important question to address is this: is your portfolio prepared for both scenarios and should it be?
12 Month Percentage Change, Consumer Price Index
Source: U.S. Bureau of Labor Statistics
First, assume this bout of rising inflation is indeed temporary. JPMorgan examined asset class performance during different inflationary environments beginning in 1988. During periods where inflation was low but rising (like now), real estate, commodities, gold, and global equities all had returns greater than 10%. This type of environment occurred four times since 1988 so this isn’t a foolproof sample size. Now if inflation falls from its high levels - as would be the case if this inflation spike is temporary – this data tells us emerging market equities, small-cap equities, value equities, high-yield bonds, and real estate assets were the places to be, while gold and commodities underperformed cash. This happened 6 times since 1988.
What if this inflation is more permanent and persistent going forward? Higher inflation is generally not a positive thing even though modest inflation can be beneficial. It may help your home value and help devalue your loans but hurts your purchasing power and savings. Persistently high inflation can also inhibit the economy – it creates uncertainty and is generally hard to reverse without causing a recession. It can also be detrimental if wage growth can’t keep up with general price levels.
Nevertheless, if we are entering into a period as described above, owning assets that benefit from inflation may be advantageous. Referencing the same JPMorgan data, a high and rising inflationary environment has occurred ten times since 1988. Emerging markets equities, growth equities, broad equities, real estate, and commodities performed. Gold kept pace with cash but failed to provide meaningful returns.
The caveats with these data are numerous. Interest rates are at multi-decade lows, U.S. equities are richly priced, technology has proven to be disinflationary if not flat out deflationary, and the COVID recovery is still driving a multitude of economic health indicators. The years ahead may look nothing like this period dating back to 1988 did.
Global supply chains are still bottlenecked trying to regain capacity lost during the pandemic to meet reopening demand and we’ve seen nature wreak havoc on certain areas of production. These hinderances along with the base effect that a few months of disinflation during the initial pandemic outbreak brought indicate this inflation may be temporary. However, the labor force slack and employers unable to find enough workers along with a Federal Reserve that seems more open to tapering rates sooner all suggest a more persistent inflation outlook. We have seen inflation expectations begin to soften a little since the initial reaction. It should be noted that inflation expectations don’t necessarily drive future inflation levels. We’ve seen peaks in expectations a few times in the last decade with little inflation actually coming to market, as shown below.
Source: Federal Reserve Bank of St. Louis
We believe it prudent not to make any major portfolio bets solely on the outlook of inflation. Broad commodities have averaged negative returns over the last 15 years and TIPS yields are currently negative. Other pieces of the economic puzzle will play as large a role or even larger roles in what unfolds over the coming years. Exeter remains diversified across equity sizes, styles, and geographies. We additionally remain flexible in our fixed income & alternative portfolios being cognizant of the potential for a persistently difficult environment for traditional bonds moving forward. Equities and real estate should damper most affects from continued inflationary shocks but having a strategic inflation-focused basket in your portfolio may be prudent if inflation is a major concern for your financial goals. Like any economic environment, maintaining discipline and a long-term view is the best path forward.