Strategic Thinking on Inflation

VOICEOVER: Welcome to the Investment Conversation. I’m Tony Fisher.

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Martini: So, you know, inflation has way overshot expectations, but people really haven't revised their the expectations they're building into financial market prices, up very sharply, at all.

Herzog: I mean, just taking us a step back and thinking about what inflation does to us in the aggregate, it creates more frequent repricing. And this is treacherous for us as investors because it does two things. First, it makes it harder to forecast, it makes it harder to see what's coming around the corner, in some sense. And it makes it harder to value assets.

VOICEOVER: We continue to receive questions about inflation: whether it’s transitory or persistent, how it affects the economy and major asset classes, and what investors can do to counter its harmful effects. Recently, Lord Abbett Investment Strategist Tim Paulson led a discussion on these topics with Partner and Director of Strategic Asset Allocation Giulio Martini and Portfolio Manager Jeffrey Herzog. We present the highlights in this podcast.

Timothy Paulson: So really just to kick things off, Giulio, I'm going to start with you. What are the you know, certainly you get Google searches, but you hear constantly transitory inflation versus persistent inflation.

Can you just talk a little bit about those dynamics and what makes something temporary, what makes something persistent, and how the market's assessing this.

Giulio Martini: inflation has risen just much more sharply during this economic recovery than anyone expected.

The Fed's summary economic projections that they published in September of 2020 expected inflation to be 1.7%. That was the median forecast for the end of 2021. And the high forecast was 2.4%. Now, here we are through September and the actual out turn is that inflation has been 4.2% driven by a sharp increase in goods prices, but services inflation is also contributing.

And if you look at what the Fed published in the most recent summary economic projections for their expectations in 2022 versus the end of 2021 it said inflation will be 2.2% and the high forecast is 3%. So there's this view as Tim alluded to at the beginning that we're going through a transitory period of higher inflation and inflation will come back down back into the range that it's been in roughly since the mid-1990s.

Now, I want to emphasize that the inflation we're experiencing right now is coming from multiple sources. the first source of inflation is just extremely strong demand for durable and non-durable consumer goods. Personal consumption expenditures are more than 10% above the trend level they would have ex been expected to be at based on pre-COVID consumer spending.

So there's a surge in those areas that's driven the price of goods up very sharply. We've also had strains on capacity at multiple points along global supply chains. I'm just showing you here shipping prices for containers, which have gone up by, you know, a mind boggling 350% plus, roughly, after rising 100% year over year at this time last year.

So shipping is extremely congested right now. There are also reallocation affects in the labor market. As people transition to better jobs, to higher paying jobs, in different sectors than they had worked on previously, that's putting pressure on labor cost. And there's a longer term shift in living preferences going on. So if you look at the next slide you know, we've experienced very strong demand for housing.

you know, you don't you didn't have to take economics 101 to figure this out housing prices are skyrocketing, up 20% year over year.

And that's gonna translate very quickly into rising rental inflation because there's about a year long to two year long lag between rising house prices and rising rents.

Now, despite all these different sources of inflation in the short term, the broad forecast in the markets is that inflation is gonna come back down.

So, you know, inflation has way overshot expectations but people really haven't revised their the expectations they're building into financial market prices, up very sharply, at all. And one of the reflection of that is in, a model that breaks down the ten year bond yield between expected increases in future short term interest rates, and then a risk premium that's compensation for the uncertainty of about future bond yields.

And that uncertainty about future bond yields is driven largely by uncertainty about future inflation. And so what we see is that the term premium has come up some in recent weeks and months, but it's still extremely low by comparison, you know, to a very long history going back into the early 1960s. And so inflation risk is not priced into bond yields at the moment.

And by virtue of not being priced into bond yields, inflation risk is you know, is not priced into stocks in our view either.

So we take that as an indication that there's really a lot of risk in in bond yields right now, a lot of risk in stock prices by virtue of their exposure to the bond yields, that if we were go get, you know, sort of a change in view on inflation, that starts to see it more as, you know, a risk that what's going on this year is more the beginning of a multi-year trend than it is just something that's gonna go away in 2022 and then revert, you know, sort of the pre-COVID norm of low and stable inflation.

You know, this is clearly, you know, probably the most significant threat to asset prices that exists right now.

Paulson: What do we think might serve as a catalyst to kind of change some of that market assessment that this is this is gonna be a temporary phenomenon?

Martini: Well, I think that's you know, from the viewpoint of investors I think it's two major things. One is I think if we start to see pressure on wages and labor costs persist and increase that that would be something that would cause investors to worry about past through into inflation more generally.

The other thing that I think would be important is for inflation forecast to continue to undershoot actual inflation.

If what we see going forward is that we continue to forecast lower inflation than actually turns out, I think that would be a signal that the underlying environment that generates inflation has changed and therefore the risk of rising inflation would be greater, and I think investors would interpret that as a rise in uncertainty, and a need for a greater risk premium associated with exposure to inflation. So I think the those are the two things that matter, labor costs, and outcomes relative to forecasts.

Paulson: Clearly we're not currently in a stagflationary environment, but that's for the boogeyman out there, what does it take to get into that? Is there a risk of this? Like, how do how do investors think about that?

Herzog: Yeah, well, you know, there were a lot of things that went wrong for the Fed in the the 1970s. And if I could just pick my the my most favorite ones is that they relied too much on certain theoretical measures of the economy like what is the the the normal rate of of unemployment we should have.

And they were also hit by a str by a set of bad luck shocks, most notably the oil shock. And we also had very different labor institutions in the 1970s, and that would be my third one, but let's focus on those two, because it's basically the idea that you get to a point where people are something to notice that inflation is higher, and that creates vulnerabilities in the economy. And then when you're vulnerable, you're hit by something you didn't anticipate and can't control.

And that really pushes the perception of inflation over the line. And I think I think that's where we got into trouble in the 1970s. The idea of stagflation really is that you have low growth and high inflation. And I don't really think that we're headed for that in the U.S. because I still see growth as pretty strong going forward.

Martini: Can I just jump in on that topic?

Paulson: Oh, please.

Martini: And add a hopefully add a little bit. I mean, I think it's stunning that, you know, you're looking from the mid-60s to the early '80s at a 15-year period of negative returns. That's a very long period of time. And the reason it's so painful is because of this condition of stagflation that essentially set in. And, you know, it's obvious why stagflation is bad, it's because you know, it's a period where growth is subpar so companies are not doing that well on the revenue line, and, you know, inflation is going up and so yields are going up.

So the discount rate you're applying to their future earnings, which are not expected to do that great, is also going up. So, you know, there's nothing to save you in that kind of environment. But on top of that, as inflation accelerates, you know, risk starts going up, because, as, you know, the Fed starts to lean against the wind, raises interest rates, tighten policy, you know, the potential for a slowdown that's large enough to raise unemployment, and increase decrease capacity utilization of the economy enough to bring inflation down, is looming.

And so, you know, the reason why stagflation is so dangerous is because it's bad for growth, it's bad for discount factors, and it's, you know, increases the uncertainty premium that investors demand. And so there's nothing good about that. And you can see, you know, how a trend acceleration of inflation ultimately culminating in this stagflationary experience was just so bad for risk assets overall for that long a period of time.

Paulson: Jeff there's a lot to talk about with that.

Herzog: I mean, just taking us a step back and thinking about what inflation does to us in the aggregate, it creates more frequent repricing. And this is treacherous for us as investors because it does two things. First, it makes it harder to forecast, it makes it harder to see what's coming around the corner, in some sense. And it makes it harder to value assets.

in periods of rising inflation you do get a get a uptick in volatility in the economy Given that this is a more treacherous environment it is incumbent upon us as investors to be more creative to think of ways that we can be more tactical and active in our allocations.

And the way we're gonna describe this is through a very simple portfolio of 60% S&P 500 and 40% ten year treasury bonds. And we have divided this times timeline into three eras, which we'll come back to also in in the future. And the first era from 1966 to 1980 is what we're gonna call accelerating inflation time period. And then from 1980 to 1995 we're gonna call this a time period of decelerating inflation. And then from 1995 forward is our our lovely and comfortable period of low and stable inflation.

And you can see in this this first period, our simplistic portfolio of 60/40 stocks and ten year treasury bonds had a cumulative negative return of about 10%. And then when we got into decelerating inflation it's cumulative return was 103%. And so I I think this really emphasizes that idea of of being creative.

I think the next question to ask ourselves is well given we that we have this asset allocation problem what can we do to navigate this regime. And again, coming back to the idea of frequent repricing, we're gonna focus on two broad buckets of of exposures that benefit from that. And the first one, is the idea to shorten duration.

You know, the the idea to shorten up duration is very simply to take advantage of the fact that short term rates in the economy are going up. And we have our three periods of in of inflation regimes here accelerating inflation, decelerating re inflation, and then low and stable inflation.

And in our first period of accelerating inflation you can see that, you know, ten year treasury bonds really didn't perform well, and the risk free rate really, really held up. And getting to a period of low and stable inflation, which not only was an era when we had conquered inflation fears, and people's expectations were very anchored on the idea of a 2% long term inflation rate.

We also had very solid periods of quantitative easing. And all this, really supported the performance of ten-year treasury bonds over the short end. Now, turning to the idea is basically the same, that we want to try to find exposures in the equity market that hold up well in this regime.

And the first one we're gonna talk about is value equities. And very from a very broad standpoint value equities have cash flows that are more near in time to us. And so when there's a broad repricing of the discount rate in the economy those exposures will hold up better than growth equity exposures. In short, value equities are less sensitive to interest rates than growth equities.

And so we have our, you know, three regimes three time periods here again, and in our first period of accelerating inflation value really, really did well versus growth during this time. And then with low and stable inflation growth equity really stages a comeback versus value. And this is an really an area where economic growth gets more scarce and value exposures didn't really hold up.

What I want to emphasize here is that we need some way to pick up which firms are handling this accelerating inflation environment well. And you can think of us as trying to seek out those firms that are trying to maintain their pricing power. And one way we can see of expressing this is through momentum as a strategy.

And what is notable is that momentum did pretty well in the acceleration accelerating inflation stage, and also managed very well the hand off to the decelerating inflation stage. I think that really speaks to momentum telling us something about which companies are navigating these turns in the economy very well. And at this point I think that we've discussed a number of good was to survive this accelerating inflation environment.

Paulson: So there's a lot going on in the world of inflation. It's clearly a risk. It destabilizes virtually every portfolio. What can investors kind of think to do actively about it?

Martini: Well, I think, you know, Jeff has laid out some factor strategies and stocks that we can use. We think value and momentum are favored during this period. We think the general idea of shortening duration in your fixed income and credit exposures you know, is a is a good idea. We think focusing on spread product is is good because you're gonna benefit from, you know, economic growth in that period, which is something that risk free yields do not do.

And so that'll be a part of fixed income that does better because it has greater economic sensitivity. Although I would add it is vulnerable to cyclical downturns. So you have to be careful you know, during the period when you're approaching recession if inflation ultimately gets high enough to trigger tightening of policy.

You know, it's a it's a it's a picture where commodities in as an asset class do okay, but it's not because all commodities do okay, it's because some do okay and some don't work during inflationary periods. So there's a broad sort of variety of experience there, and it's really important to be sensitive to the commodities that are in a good position as you're entering inflation.

Also portions of real estate, because of repricing, frequent repricing in things like commercial real estate, you know, that very often have escalators built into them for increases in prices. And then I think the other thing which isn't really focused on as much is to be long volatility exposure. You know, inflation going up over a prolonged period of time is gonna introduce rising volatility into asset prices.

And so being long volatility in that environment is a strategy, you know, whether it's volatility in stocks, whether it's volatility in rates, whether it's volatility in FX you know, that's a strategy that's gonna win over time. So it's kind of a cross-asset exposure to rising volatility is also something that will very likely work well as you're moving from sort of low inflation into higher inflation.

Voiceover: Our experts will have more to say about this important topic in a future podcast. Meanwhile, you can hear Jeff Herzog talk about reconsidering the impact of Covid on the global economy, and Giulio Martini’s take on the “Humpty Dumpty” U.S. economic recovery, in other episodes of the Investment Conversation. I’m Tony Fisher. ETC

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Disclosure

Gross Domestic Product (GDP): The monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments, and exports less imports that occur within a defined territory.

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