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Fixed-Income Insights

Increases in commodity prices, and housing and healthcare costs, are not likely to push U.S. inflation notably higher.

 

In Brief

  • Higher commodity prices and rising housing costs and healthcare prices have raised concerns about a rise in U.S. inflation, as evidenced by higher sales of U.S. Treasury inflation-protected securities (TIPS).
  • But these fears, in our opinion, may not be warranted. While higher oil prices likely will push year-over-year inflation readings higher in the near term, those comparisons eventually will ease, given that further increases in oil are unlikely.
  • Further, China-fueled increases in commodity prices appear to be only temporary.
  • Turning to the United States, recent increases in healthcare and housing costs do not appear poised to push the U.S. Consumer Price Index (CPI) notably higher. 
  • The key takeaway—For those who wish to adjust their portfolios to a prospective resurgence in inflation, an event that appears unlikely, we believe there are better alternatives than TIPS.

 

Could the long-awaited revival of U.S. inflation finally be at hand? Higher commodity prices, including energy, metals, and agricultural products, have combined with rising housing costs and healthcare prices to raise concerns that higher inflation is about to emerge. Providing some support to those concerns is that the U.S. Federal Reserve Bank of St. Louis’s five-year, five-year forward inflation-expectation rate recently rose, from a low of about 1.4% in July 2016 to 1.87% as of the last week in October. 

Even though this latest reading is still low by historical standards, some investors have acted in anticipation of inflation, as reflected in the sales of U.S. Treasury inflation-protected securities (TIPS). The Wall Street Journal recently reported that mutual funds and exchange-traded funds targeting TIPS attracted $6.2 billion in new monies through October 28, the biggest calendar-year inflow since 2011. 

Investors mindful of the deleterious effect of rising prices for goods and services probably have two key questions: Are inflation concerns warranted? And are TIPS an effective strategy in a rising-rate environment? We’ll try to answer each.

Crude Math
Without a substantial supply shock, such as a major disruption in oil production, or a dramatic boost in economic growth, U.S. inflation seems unlikely to rise to concerning levels. Crude oil at $50 per barrel, compared with levels below $30 in January and February, seems destined to push higher the year-over-year readings for the headline U.S. Consumer Price Index (CPI). 

However, any increase in oil prices from current levels seems dependent on a reduction in supply, courtesy of an agreement among members of the Organization of Petroleum Exporting Countries (OPEC), or additional closures of U.S. oil wells. Neither seems probable, in our view. OPEC infighting has so far prevented agreement on even a 2% reduction in output, not to mention the likely cheating (historically evident) even if an agreement had been reached. Further, the United States continues to deploy more oil rigs, not fewer. And the abundance of U.S. wells drilled but not yet pressed into production via hydraulic fracturing implies shadow supply that could become available at even marginally higher prices, capping any additional price increases.

Blame China?
Other commodities that have jumped higher recently have been influenced by government policy, particularly in China. For example, new weight limitations on trucks (effective September 21) reduced the maximum load, from 55 tons to 49 tons, temporarily causing aluminum shortages and higher prices, according to The Wall Street Journal. Similarly, China’s efforts to eliminate inefficient producers of metallurgical coal have cut production by 26% since 2014, according to research from Cornerstone Macro, leading to shortages and related price hikes. Recent production suggests at least a partial reversal of this policy in order to alleviate the shortages and the price pressures. 

Prices for iron ore, copper, and zinc also may have benefited from China’s actions in the form of economic stimulus earlier this year. Research by Cornerstone Macro suggests that stimulus has already started to fade and the commodities (and countries) that benefited could soon be at risk of weakening.  

Domestic Factors
While China may bear some responsibility for recent hikes in commodity prices, other aspects of U.S. inflation have been driven largely by domestic activity. The housing component of the CPI (a persistent above-average contributor to the index) is up 3.4% over the past 12 months, based on the most recent September figures from the U.S. Bureau of Labor Statistics, not dissimilar to most reports throughout 2016. Similarly, medical care (also a reliable above-average contributor) was up 4.9% from a year earlier.  Yet neither of these are outliers in terms of factors poised to push the CPI notably higher. 

The one factor that could influence the CPI over the next few months is oil. As previously noted, if oil remains at $50 per barrel, the January and February 2017 CPI figures could provide the opportunity for the widest year-over-year disparities. The only time oil traded below $30 per barrel in the past 12 months was in January and February 2016, reaching $26.55 on January 20 and $26.21 on February 11, according to Investing.com. As a result of such a low prior-year base, Barron’s reports that Citi economists estimate that headline CPI should jump, to 2.7%, by next February’s reading, compared with 1.5% for the most recent September report. 

That would be an appreciable jump, by any measure. However, if oil prices remain at about $50 per barrel beyond February, the impact will be short-lived. Year-over-year comparisons likely will quickly narrow as the underlying base moves higher. Oil averaged more than $49 per barrel as recently as April 2016, meaning the year-over-year comparisons for crude may actually temper headline annual CPI by April 2017, in contrast to the boost it provided only two months earlier.  

Other inflationary pressures, however, are not readily apparent. U.S. economic growth of about 2% is unlikely to produce outsized demand or supply imbalances that provide broad-based support to higher prices. Wage gains consistently have ranged 2.4–2.6% throughout 2016, offering little provocation to price hikes. Presidential politics promise some hope of boosting economic growth via infrastructure spending, but the effects of that would take a while, considering the time that would elapse to pass budgeting legislation, identify priorities, and disseminate the funds; therefore, any possible contribution to inflation would not occur in the near future. In addition, even if such fiscal stimulus does come to fruition, hope of its success will be reflected in higher stock prices, expectation of growth will spur interest rates higher, and the U.S. Federal Reserve, insistent on higher rates, likely will begin its path toward rate normalization. 

Investment Considerations
Thus, the factors likely to produce inflation may first produce higher interest rates. In such an environment, the duration or volatility of TIPS, which is substantially higher than the volatility of similar-maturity U.S. Treasury securities, could cause far more damage to investors’ bond principal than the “benefit” created by higher inflation. Instead, a short-duration portfolio that purchases CPI swaps may be a far more effective alternative. CPI swaps can capture the change in CPI, while the underlying portfolio invests in short-term, higher-yielding securities, such as corporate bonds and commercial mortgage-backed securities. The combination offers lower volatility and higher yield than TIPS, while capturing the same movement in CPI.

Alternatively, in an environment of slowly rising interest rates, wherein inflation increases may be short-lived or slow to arrive, fixed-income sectors, such as high-yield, bank loans, and short-duration multi-sector portfolios, offer relatively attractive income with relatively low volatility. 

In conclusion, inflation does not appear to be an imminent problem, but for those who wish to adjust their portfolios to its prospective resurgence, there are, we believe as an active manager, more rewarding strategies than TIPS to address the potential consequences. 

 

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