Investing amid Inflation Uncertainty | Lord Abbett
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Economic Insights

So far, inflation has not accelerated after massive U.S. fiscal stimulus—but it’s still early in the game. Giulio Martini shares his insights on the implications for investors.

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Transcript
<p>VOICEOVER: Welcome to the Investment Conversation. I’m Tony Fisher. </p> <p>*music hits*</p> <p> [AUDIO SNIPPETS] </p> <p>Snippet 1 </p> <p>If there really is an intention to run the economy hot enough to produce a really tight labor market for a long period of time, then that could well feed into accelerating wage growth. And accelerating wage growth is the key to a change in the long-term inflation regime. </p> <p>SFX: Tea kettle/steam whistle</p> <p>Voiceover: If the U.S. economy runs hot, does inflation return to a boil for the first time in decades? After the rollout of COVID-19 vaccines and the implementation of the American Rescue Plan, markets are wondering whether a stimulus-driven boom may lead to a rise in inflation beyond the U.S. Federal Reserve’s 2% target. </p> <p>How might investors position their portfolios in response to potential developments on the inflation front? To gain some perspective on these and other topics, my colleague Will Andrews recently sat down with Lord Abbett Partner & Director of Strategic Asset Allocation Giulio Martini. </p> <p>Will Andrews: So, Giulio, you've been following the inflation story closely, including two recent Economic Insights commentaries published on LordAbbett.com. Now, so far the remarkable amount of stimulus delivered by the U.S. government has not caused inflation to run hot despite a few concerning signals. What has gone right in that regard? </p> <p>Giulio Martini: Well, I-- I think, Will, you're absolutely right that things have gone right because-- as we're talking, you know [late April 2021] -- the U.S. stock market's up-- about 11.5% for the year. And it would not be doing so well if people were becoming much, much more worried about inflation. </p> <p>So notwithstanding, you know, this record fiscal stimulus, the buildup in debt that we've had-- the recovery in the economy, the sprint towards reopening-- what we've found out really is that-- long-term inflation expectations are extremely well anchored. </p> <p>They haven't moved very much, despite these fundamental changes in the economy. And I think, you know, that's very interesting. And maybe it shouldn't be that much of a surprise because the inflationary regime that we've been in has prevailed for 25 years now. </p> <p>So regime changes are rare. You know, the current regime is extremely well embedded. And I think we're just finding out how deeply rooted those expectations are that inflation will stay low and well anchored. Now, that could be challenged soon. We're coming up on a period-- when that could well be challenged. </p> <p>Andrews: So let's go to the flip side of my last question. What could go wrong regarding inflation? And, more important, what are the potential consequences we might be looking at? </p> <p>Martini: Well, I really want to divide my answer on inflation into two parts. One is sort of let's call it the next 12 months-- when what we're going to see is a lot of forces potentially converging that could produce a t-- a period of higher inflation. </p> <p>And what I have in mind is, you know, the economy naturally is reopening as vaccinations, you know, proceed and reach a larger and larger share of the population. That's going to bring spending back in certain areas like restaurants, like airline travel and hotels that people haven't been to before. </p> <p>And I think we could well see some price increases there as businesses really try and recoup some of the losses-- that they've suffered. Simultaneous with that-- you know, we're also seeing big increases in job creation as people go back to work. So that's going to add to consumer demand. </p> <p>And of course we have the residual effects of the stimulus-- that's been applied. So, you know, consumer balance sheets are in very good shape. And one of the real large question marks in this period is: What happens to this very large pool of savings that was created-- during the aggressive fiscal stimulus which rolled out over the past year? </p> <p>Are people going to continue to hold on to that-- and just feel like they need higher savings and-- and higher levels of assets because of the uncertainty that they're facing? Or, as the economy comes back fully, are they going to start to feel more comfortable and spend some of those savings down? </p> <p>Because if they do, you know, then it's really going to kind of turbocharge demand and we could see this burst of higher prices which I think investors would tend to interpret as higher inflation. And I think this is an issue that will play out over the next 12 months roughly. </p> <p>Andrews: And if we look beyond the next 12 months? </p> <p>Martini: Now, beyond that, there's the issue of are we building to a regime change where people will start to expect higher inflation in the long run than we've had since the mid-1990s. And I think the case for that really rests on policy makers wanting to run the economy hot enough so that some of the disadvantaged groups in the labor market who have lower wages, who have worse job prospects, who really would benefit more from long employment tenures and the training that comes with that. </p> <p>If there really is an intention to run the economy hot enough to produce a really tight labor market for a long period of time, then that could well feed into accelerating wage growth. And accelerating wage growth is the key to a change in the long-term inflation regime. </p> <p>That's what created the upturn in inflation in its early stages at the end of the 1960s. And the opposite resulting from high unemployment was what broke the back of inflation very quickly in the early 1980s. And so I think we really have to look to wages-- to see what happens with inflation over the longer term. </p> <p>And that really is a question probably that won't be resolved until we see the response of policy makers when the labor market has tightened because of reopening and stronger growth over the next 12 months. How do they react then? Do they let it run? Because then the inflationary genie could come out of the bottle. </p> <p>And the way we would see that is through rising long-term inflation expectations and an inflation risk premium being priced into markets. And that's really what investors have to be wary of-- you know, because a rising inflation risk premium means rising long-term yields. Rising long-term yields are just, you know, an unambiguous bad [thing] for asset owners. </p> <p>Andrews: So, Giulio, I'm going to go off-script here. I find it very interesting that there’s a social dimension to this that maybe we don't have in prior policy episodes. Is this something new and different? </p> <p>Martini: No, I don't think it is. I think it's always a matter of political economy. And inflation really is very much a result of broader social policy decisions. So, you know, the decision during the 1960s during the Civil Rights era really was that we needed to hold the unemployment rate at very low levels to produce a more inclusive economy that would be open and good job prospects for everyone. </p> <p>Now, a lot of things happened after that, you know, to feed the high inflation. We had, you know, a big increase in food prices because of a crop failure in 1972. We had the first oil price shock in 1973. And then we had another oil price shock at the end of the 1970s. So, you know, things sort of fed off of each other. </p> <p>But I think the initial seed for the inflation was planted as a result of social policy. And you know, in the early 1980s, the decision was made after repeated failures to bring inflation down, right, after we'd had a recession in '69-'70, a very deep recession in '74-'75. </p> <p>You know, the Nixon administration used wage and price controls in 1971 to try-- we had had repeated failures to bring inflation down. And the decision was made, "Well, you know, we're willing to suffer a period of high unemployment to get the inflation rate down again, you know, into the low single digits," from what had been as high as 14.8%. </p> <p>And so we had unemployment at almost 11%-- in the '81-'82 recession. And that indeed broke the back of inflation. But, you know, you had to make a decision that the pain was worth taking to get to that point. And now, you know, we're seeing a lot of signs around us that-- you know, our society is sort of shifting in some ways-- as-- you know, with respect to its preferences. </p> <p>You know, we see a big emphasis on ESG, for instance, investing, which we'd never seen before that really is reordering-- the kinds of attributes that investors want to see in their portfolios. You know, this seems to be a very, very broad-based movement. </p> <p>We're also seeing, you know-- a preference for increased diversity-- you know, for opportunities for-- women and for-- you know-- groups like Blacks, and Asians, and Hispanics to really participate truly and more fairly-- in the distribution of income and wealth. </p> <p>And, you know, these are changes that-- are fundamental to the way the economy operates. And, you know, if one of those is that we require a tight labor market to get these done, well, that trumps sort of the imperative of the last 40 years, which was to keep inflation low and then everything else would take care of itself. </p> <p>We're kind of rejecting, you know, that paradigm in favor of something that's more active, that's more intentional, that may well involve accepting a higher level of inflation. And, you know, we'll see how that gets priced. The danger of that of course is that, you know, the reason that investors are not worried about deficits and debt right now is because interest rates are very low. </p> <p>But if interest rates start rising, all of a sudden that kind of apathy is going to disappear very quickly. And of course these things can spiral on each other. And honestly, we don't have very good models to explain how that happens because there are very few historical instances of these changes. </p> <p>So we don't know how markets are going to react-- you know, potentially to the kind of changes we're-- we're seeing-- maybe begin right now. </p> <p>Andrews: This uncertainty tees up my next question, which is how investors should approach the potential outcomes we’re talking about today. </p> <p>Martini: Well, the thing I'd want to say first is that it's true early to make any changes in your portfolio strategy, in your asset allocation based on a view about whether inflation is going to stay low and stable or start to accelerate. It is simply too early. We don't know. </p> <p>The risk is there. But, you know, it's a risk that probably starts to manifest a year, 18 months, you know, 24 months from now. So it's too early to anticipate disruption that's related to that. </p> <p>If in fact inflation does begin to accelerate, what you want to own are things that reprice very rapidly. And so what reprices very rapidly? Well, T-bills, you know, reprice very rapidly. They-- you know, short-term interest rates rise. And, you know, if you look at the 1970s, they were very much a source of-- you know, better real returns-- during that period than-- than longer-duration assets. </p> <p>I think you might want to own commodities-- because a strong economy, you know, tends to push-- the prices up of things that are in fixed supply, which commodities tend to be over the short run. And I think you really want to look at stocks of companies that can either maintain their profitability because they have pricing power or because they can cut costs enough to really maintain their margins. </p> <p>And it's very difficult to say what kinds of companies those are. But in terms of factors in the stock market, inflationary periods are good times for momentum strategies that really, you know, capitalize on things that reveal themselves to be able to do well in this environment. </p> <p>So you might need to have a more active strategy than stocks to be able to capitalize on positive momentum and stay away from-- you know, whoever's being hurt by it. And it's very difficult to specify ahead of time what those companies might be. </p> <p>On the other hand, you know, if we-- stay in a low-inflation, low-volatility environment, what you want to own are things-- that can deliver benefits in the very long term-- over a long horizon. So what kind of things are that? Well, they tend to be longer-duration bonds, longer-duration assets in general-- credit-- and I would say-- innovation-type growth stocks-- more than anything else. </p> <p>So the basic idea to keep in mind is that, you know, in an inflationary period you want things that reprice very quickly. In a disinflationary period, you want things that really deliver benefits over a long time horizon. I should also mention in that latter vein that things like real estate, you know, and infrastructure investments that have long flows of payments and rents are things that are much better suited for a low-inflation, low-volatility environment than some other things. </p> <p>Andrews: What does your gut tell you about the direction of inflation? I know we've presented a whole bunch of possibilities. But, you know, do you have-- a sort of view about where things might be? Or, you know, could things begin to accelerate? Or will things, you know, stay pretty much the same? Do you-- do you have sort of a--</p> <p>Martini: Well. </p> <p>Andrews: --feeling on that? </p> <p>Martini: You know what I'm going to do, Will? I'm going to duck that question because, you know, I'm going to duck it because I want to just emphasize how uncertain a period that we're in, you know? And, you know, we've never had a global pandemic for the last 100 years, and recovery from a global pandemic. </p> <p>So who really knows what's going to play out? We've never had a situation, you know, where fiscal policy has-- you know, gone into deficit by 27% of GDP over the past year-- you know, and built up debt this rapidly. How is that going to play out? The truth is we don't know. </p> <p>And-- so I'm not going to pretend like I know. And what that means is that, you know, my gut is just not telling me anything except for, "Be on your toes, be ready to change, you know, and-- and-- be ready to un-- entertain the different possibilities." </p> <p>None of this is decided yet. And, you know it's just too early to decide which road we're going on, even though we know one, you know, could be a yellow-brick road and one could be the road to perdition, right? So, you know, don't be fooled by the greater attractiveness of thinking you're on the road to perdition because that's just human nature and risk aversion, you know, pulling you down that path. Nobody really knows how this is going to turn out yet. </p> <p>Andrews: Well, Giulio, this has been a fantastic conversation. There’s a lot to follow here. </p> <p>Martini: Well, we'll see. I'm fascinated by it. There are going to be a lot of twists and turns along the way. It's going to be a really, really interesting period and, you know, a real challenge where-- you know, these are the kind of periods where I think active management-- can prove its mettle and really justify itself, you know? </p> <p>So I'm looking forward to investing through it and trying to think my way through it along with my team and with my colleagues in other investment areas at Lord Abbett. It's going to be very challenging. </p> <p>Andrews: We'd love to hear your insights in the months to come. And I'm sure we'll be catching up with you before long. So thanks for being with us today, and we'll talk to you again soon. </p> <p>Martini: Great, Will. Take care, and-- goodbye, everyone. </p> <p>Andrews: If you'd like a transcript of today's podcast or have any further questions on inflation-related investments, please contact your Lord Abbett representative. And, as always, you can read more economic insights from Giulio Martini on Lord Abbett.com. </p> ________________________________________ <p>VOICEOVER: Subscribe and rate us on Apple Podcasts, Spotify, or your favorite streaming app of choice. Thank you for listening. </p> ________________________________________ <p>VOICEOVER: </p> <p>Duration is the change in the value of a fixed-income security that will result from a 1% change in market interest rates. Generally, the larger a portfolio’s duration, the greater the interest-rate risk or reward for underlying bond prices. </p> <p>GDP refers to gross domestic product. </p> <p>A risk premium is the investment return an asset is expected to yield in excess of the risk-free rate of return. </p> <p>A U.S. Treasury Bill, or T-Bill, is a short-term U.S. government debt obligation backed by the Treasury Department with a maturity of one year or less. </p> <p><p>Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies. </p> <p>The credit quality of the securities in a portfolio is 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. </p> <p> Investing involves risk, including the loss of principal. The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. The municipal market can be affected by adverse tax, legislative, or political changes, and by the financial condition of the issuers of municipal securities. Investments in foreign or emerging market securities, which may be adversely affected by economic, political, or regulatory factors and subject to currency volatility and greater liquidity 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. </p> <p>No investing strategy can overcome all market volatility or guarantee future results. </p> <p> Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. </p> <p>The views and opinions expressed by the Lord Abbett speaker are those of the speaker as of the date of the broadcast, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions and Lord Abbett disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research or investment advice. It is not a recommendation, offer or solicitation to buy or sell any securities, or to adopt any investment strategy. Neither Lord Abbett nor the Lord Abbett speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered. </p> <p>Note to European Investors: This communication is issued in the United Kingdom and distributed throughout Europe by Lord Abbett UK Ltd., a Private Limited Company registered in England and Wales under company number 10804287 with its registered office at Tallis House, 2 Tallis Street, Temple, London, United Kingdom, EC4Y 0AB. Lord Abbett UK Ltd (FRN 783356) is an Appointed Representative of Duff & Phelps Securities Ltd. (FRN 466588) which is authorised and regulated by the Financial Conduct Authority. This broadcast is the copyright © 2021 of Lord, Abbett & Co. LLC. All Rights Reserved. This recording may not be reproduced in whole or in part or any form without the permission of Lord Abbett. </p>

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