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Large fiscal deficits and extraordinarily accommodative monetary policy—not just in the United States but also around the world—have led many investors to worry about inflation. Yet the Consumer Price Index (CPI) rose just 1.7% in 2012, well below the 30-year average of 2.9%. And with the exception of 2007, inflation has remained below that long-run figure every year since 2006. So, should investors be worried about pricing pressures, or not?
Source: Source: Bloomberg.
* As of 01/31/2013, the expected inflation of 2.53% is the five-year breakeven rate of inflation as currently priced in the CPI swap market.
That inflation has been low is not to say that it will remain so. In fact, inflation expectations point to higher rates over the next five years. But even if pricing pressures do remain minimal, that does not mean their effect is negligible. According to CPI data, prices today are 15.6% higher than they were just seven years ago. So, even when inflation is relatively low, it still erodes purchasing power over the long run.
Source: Source: Lord Abbett.
1 Barclays Government Credit Aaa +1–3 Yr. 2Ibbotson Associates: SBBI—U.S. Inflation. 3Deutsche Bank Breakeven 5-Yr. CPI. 4Barclays U.S. Treasury. 5Barclays U.S. Treasury TIPS. 6S&P 500. 7S&P GSCI Gold. 8S&P GSCI. 9S&P 500 U.S. REIT Index.
Investors may want to consider inflation protection as a part of their portfolio. Mindful of the need for such protection, investors have often opted for real estate, various commodities, and Treasury inflation-protected securities (TIPS). Yet each of these strategies comes with significant drawbacks. Returns on real estate investment trusts (REITs), for example, can be highly volatile; the standard deviation on return over the past 10 years is more than 27%. Commodities can be similarly unsettled. In addition, not all commodities are highly correlated with inflation, so choosing the right ones can be critical.
TIPS, on the other hand, have been more stable over the past 10 years. But even these hold the potential for greater volatility, given that they come with some duration risk. As of February 8, 2013, their duration on the benchmark U.S. TIPS Index was 8.8 years, so a significant rise in interest rates would make a noticeable dent in principal. In addition, most of the inflation protection comes not as an adjustment to the coupon rate but as an increase in principal years later when the bond is repaid. So investors hoping their income will keep pace with price increases will be disappointed.
Alternatives that could offer better protection are floating-rate loans, short-duration credit strategies, and inflation swaps, according to Zane Brown, Lord Abbett Partner and Fixed Income Strategist. In fact, "combining short-duration securities with CPI swaps offers the possibility of both an attractive income stream and some capital appreciation if inflation should rise significantly."
All links are directed to Lord Abbett's website.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.
Past performance is no guarantee of future results. Current performance may be higher or lower than the performance data quoted. All indexes are unmanaged and do not reflect reinvestment of dividends and distributions, deduction of management fees, or operating expenses. An investor cannot invest directly in an index.
Investors should consult with a financial advisor on the strategy best for them based on their individual goals, risk tolerance, and investing time horizon.
Neither diversification nor asset allocation can guarantee a profit or protect against loss in declining markets.
A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The value of investments in fixed-income securities will change as interest rates fluctuate. As interest rates fall, the prices of debt securities tend to rise, and as interest rates rise, the prices of debt securities tend to fall. Investments in high-yield securities (sometimes called junk bonds) carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Income from municipal securities may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. No investing strategy can overcome all market volatility or guarantee future results.
Foreign securities generally pose greater risk than domestic securities, including greater price fluctuations and higher transaction costs. Foreign investments also may be affected by changes in currency rates or currency controls. With respect to certain foreign countries, there is a possibility of nationalization, expropriation, or confiscatory taxation, imposition of withholding or other taxes, and political or social instability that could affect investments in those countries. The securities markets of emerging countries tend to be less liquid, to be especially subject to greater price volatility, to have a smaller market capitalization, and to have less government regulation, and may not be subject to as extensive and frequent accounting, financial, and other reporting requirements as securities issued in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions. Foreign currency exchange rates may fluctuate significantly over short periods of time. They generally are determined by supply and demand in the foreign exchange markets and relative merits of investments in different countries, actual or perceived changes in interest rates, and other complex factors. Currency exchange rates also can be affected unpredictably by intervention (or the failure to intervene) by U.S. or foreign governments or central banks, or by currency controls or political developments.
While municipal bonds are backed by municipalities, U.S. government securities, such as U.S. Treasury bills, are considered less risky since they are backed by the U.S. government. High-yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.
Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.
Price-to-earnings ratio is the price of a stock divided by its earnings per share.
Breakeven data are from Bloomberg. Breakeven rates are calculated by subtracting the rate on a TIPS issue from a nominal Treasury issue of an equivalent maturity. It provides an indication of the expected rate of inflation at a future date.
Standard deviation is a measure of the volatility or variability of returns. The higher the standard deviation, the greater an investment's risk because of greater volatility means more uncertainty about the size of the return.
Barclays Government/Credit Aaa 1-3 Year Index is designed to represent a combination of the Government Bond Index and the Corporate Bond Index and includes U.S. government Treasury and agency securities, corporate bonds, and Yankee bonds.
The Ibbotson Associates SSBI-U.S. Inflation Index is designed to track the U.S. rate of inflation.
The Deutsche Bank 5-Year CPI Swaps Index is provided by Deutsche Bank AG and is based in U.S. dollars, provides intraday price frequency, and is subject to a one-day lag. It is designed to track the performance of five-year CPI swaps.
The Barclays U.S. Treasury Index measures the performance of the U.S. Treasury bond market. Using market capitalization weighting and a standard rule-based inclusion methodology, the index accurately reflects the performance and characteristics of the Treasury market.
The Barclays U.S. Government Inflation-Linked Bond Index (U.S. TIPS) measures the performance of the TIPS market. TIPS form the largest component of the Barclays Global Inflation-Linked Bond Index. Inflation-linked indexes include only capital-indexed bonds with a remaining maturity of one year or more.
The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
The S&P GSCI Gold Index is a subindex of the S&P GSCI and provides a benchmark for tracking COMEX gold futures.
The S&P GSCI is calculated primarily on a world production weighted basis and comprises the principal physical commodities that are the subject of active, liquid futures markets.
The S&P U.S. REIT Index measures the securitized U.S. real estate investment trust market. The index covers about 89% of the U.S. REIT market capitalization, and maintains a constituency that reflects the market's overall composition.
Duration is a measure of the sensitivity of a bond's price to changes in interest rates.
The benchmark U.S. TIPS index refers to the Barclays U.S. Government Inflation-Linked Bond Index (U.S. TIPS), which measures the performance of the TIPS market. TIPS form the largest component of the Barclays Global Inflation-Linked Bond Index. Inflation-linked indexes include only capital-indexed bonds with a remaining maturity of one year or more.
Coupon is the interest rate on a bond that is expressed at the bond's face value, or par.
The Consumer Price Index (CPI) measures the price changes for each item in a predetermined basket of goods and services, and the inputs are weighted according to their importance to consumers.
Treasury Inflation Protected Securities (TIPS) are treasury securities that are indexed to inflation in order to protect investors from the negative effects of inflation. TIPS are considered an extremely low-risk investment since they are backed by the U.S. government and since their par value rises with inflation, as measured by the Consumer Price Index, while their interest rate remains fixed.
Real Estate Investment Trusts (REITs) are securities that sell like stocks on the major exchanges and invest in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.
A CPI Swap is a derivative used to transfer inflation risk from one party to another through an exchange of cash flows. In an inflation swap, one party pays a fixed rate on a notional principal amount, while the other party pays a floating rate linked to the Consumer Price Index (CPI). The party paying the floating rate pays the inflation adjusted rate multiplied by the notional principal amount.
The credit quality ratings of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from AAA (highest) to D (lowest). Bonds rated BBB or above are considered investment grade. Credit ratings BB and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities. Credit quality distributions breakdown is not an S&P credit rating or an opinion of S&P as to the creditworthiness of the portfolio.
The S&P 500® Index is a market capitalization-weighted index of common stocks.
The S&P 500® Index Excluding Financials is a subset of the S&P 500 Index that excludes the financial sector.
The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.