Countering a Potential Inflation Threat | Lord Abbett
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Market View

Our experts examine whether the current bout of inflation may be “transitory” or “persistent,” along with potential investment approaches for the current environment. 

 

Read time: 5 minutes

With numerous headlines about supply-chain bottlenecks and rising cost pressures in key areas of the economy, the potential for a sustained period of higher inflation remains a key topic in investment conversations. Recently, Lord Abbett Investment Strategist Timothy Paulson led a discussion on inflation and its implications for investors with Partner and Director of Strategic Asset Allocation Giulio Martini and Portfolio Manager Jeffrey Herzog. Edited excerpts from their remarks follow:

Timothy Paulson: You constantly hear talk of “transitory inflation” versus “persistent inflation.” The U.S. Federal Reserve (Fed) has largely indicated that it doesn’t see current inflation readings leading to something that will be more persistent. The market tends to agree. Can you just talk a little bit about those dynamics?

Giulio Martini: Inflation has risen much more sharply during this economic recovery than anyone expected. In the Fed's summary economic projections published in September 2020, they 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 2021, and the actual outcome is that inflation has been 4.2%, driven by a sharp increase in goods prices, though services inflation is also contributing. The Fed’s most recent, summary economic projections for 2022 versus the end of 2021 call for inflation at a rate of 2.2%, with a high forecast of 3%. That reflects the Fed’s view that we are experiencing 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. We’re seeing extremely strong demand for durable and non-durable consumer goods. Personal consumption expenditures are more than 10% above the trend level they would have expected to be at, based on pre-COVID-19 consumer spending. We've also had strains on capacity at multiple points along global supply chains, including soaring prices for shipping containers.

There are also pressures in the labor market. As people transition to better jobs, to higher paying jobs, in different sectors than they had worked in previously, that's putting pressure on labor costs. Meanwhile, supply-and-demand factors have driven home prices sharply higher. We expect that to translate very quickly into rising rental inflation because there's about a one- to two-year lag between rising house prices and rising rents. Transitory or not, we think these factors will press higher on inflation for the next one to two years.

Despite all these different sources of inflation in the short term, the broad forecast in the markets is that inflation will come back down. If you look at expectations baked into market prices, in this case, the five-year, five-year forward inflation swap, the left panel of Figure 1 shows that they are still at a level close to or below what they were before the big drop in oil prices in 2014. Meanwhile, the risk premium that represents compensation for the uncertainty about future bond yields remains very low (right panel).

Basically, inflation has way overshot forecasts, but people really haven't revised the expectations they're building into financial market prices at all.

 

 

Figure 1. Investors Appear Complacent about Inflation Risk
U.S. five-year, five-year forward inflation swap (left panel; in percent), July 1966­–September 2021, and estimated 10-year U.S. Treasury term premium (right panel; in percent), July 1961–September 2021

Source: Bloomberg and Lord Abbett. Data as of October 5, 2021. 
An inflation swap is a contract used to transfer inflation risk from one party to another through an exchange of fixed cash flows; five-year, five-year forward inflation swaps are tied to a measure of expected inflation (on average) over the five-year period that begins five years from today.
Term premium is a gauge of the level of risk inherent in holding a longer-term bond versus a series of shorter-term securities. It represents the estimated risk embedded in a longer-maturity bond that is determined by the difference between the actual yield and the “risk neutral” yield (represented by rolling a series of shorter-term securities extending to the same maturity at current rate expectations).
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 


Bottom line, while the term premium has come up some in recent weeks and months, it's still extremely low by comparison with a very long history going back into the early 1960s. And so, inflation risk is not priced into bond yields now. And by virtue of not being priced into bond yields, inflation risk is not priced into stocks in our view either. We think the prospect of a significant, sustained rise in inflation is probably the most significant threat to asset prices that exists right now.

Paulson: For investors, what are the implications of hotter-than-expected inflation and a rising risk premium?

Jeffrey Herzog: To answer that, let’s take a step back and think about what inflation does to us in the aggregate: it creates more frequent repricing. The potential difficulties for investors are twofold. First, it makes it harder to forecast; it makes it harder to see what's coming around the corner. Second, it makes it that much harder to value assets.

That difficulty springs from the potential impact that inflation can have on economic growth. Figure 2 shows the standard deviation of Treasury yield changes in a five-year window, and the standard deviation of GDP in a similar timeframe. In a nutshell, periods of rising inflation can lead to volatility in the economy.

 

Figure 2. Periods of Sustained Inflation Have Led to Higher Rate and Economic Volatility
Five-year rolling standard deviation of monthly 10-year U.S. Treasury yield changes (Left panel), July 1966–September 2021; five-year standard deviation of quarterly annualized GDP growth (right panel), July 1966–September 2021

Source: Bloomberg and Lord Abbett. Data as of October 5, 2021.
Standard deviation measures the dispersion of data from the mean and is an indication of the volatility of a data series.
For illustrative purposes only. Past performance is not a reliable indicator or guarantee of future results
.

 

The historical risks from a period of accelerating inflation are clear for risk assets such as equities, as Figure 3 shows.

 

Figure 3. Tracking Stocks’ Performance Through Various Inflation Regimes
Cumulative return of S&P 500 Index, June 1966–September 2021

Source: Bloomberg and Lord Abbett. Data as of October 5, 2021.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is not a reliable indicator or guarantee of future results.

 

The first portion of the chart covers a period of accelerating inflation from 1966–1980. During that 14-year period, the S&P 500® Index had a cumulative return of only about 32%. During the period of decelerating inflation from 1980-early 1995, its cumulative return was 414%. (The results from the long-term regime of low and stable inflation from 1995 onward speak for themselves.)

But the data that we are looking at now do not point to a period of decelerating inflation. I think this really underscores the importance of being adaptive and creative in formulating investment approaches during periods when inflation may be poised to accelerate.

Paulson: There's a lot going on in the world of inflation. It's clearly a risk. It destabilizes virtually every portfolio. To Jeff’s point, what approach can investors take to prepare their portfolios for a potential period of accelerating inflation?

Martini: In equities, we think value and momentum are favored during periods of rising inflation. We think the general idea of shortening duration in your fixed-income and credit exposures is a good idea. We think focusing on spread product1 is a good idea because it could potentially benefit from higher economic growth in that period, which is something that risk-free yields do not do. Those bonds may be poised to do better because of their greater sensitivity to changes in the rate of economic growth, although I would add they may be vulnerable to cyclical downturns.

Of course, many investors may consider commodities in such an environment, but we would note that all commodities respond well during inflationary periods. Certain areas within real estate may also perform well.

We envision an effective overall response to rising inflation as kind of a cross-asset exposure to rising volatility, something that may prove effective as you move from a period of low inflation to higher inflation.

Paulson: As we wrap things up, I think one important point to note is that it's extremely difficult to forecast inflation, let alone very long-term inflation. As Giulio has said, inflation is a process, not an event. Ultimately, what we’re saying here is not that inflation is bound to move sharply higher for a sustained period. Rather, it’s that some of the risks around inflation may not be adequately priced into the market right now.

 

1Spread product refers to taxable bonds that are not Treasury securities. They are evaluated by the professionals who buy and sell them based on the difference between their yield and the yield of a comparable Treasury security.

 

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

Market forecasts and projections are based on current market conditions and are subject to change without notice.

Projections should not be considered a guarantee.

Equity Investing Risks

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. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies.

Fixed-Income Investing Risks

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. 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. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. The securities markets of emerging market countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation, and may not be subject to as extensive and frequent accounting, financial, and other reporting requirements as securities markets 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.

The credit quality of fixed-income 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.

This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The views and opinions expressed are as of the date of publication, 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. Lord Abbett cannot be responsible for any direct or incidental loss incurred by applying any of the information offered.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

Please consult your investment professional for additional information concerning your specific situation.

Glossary & Index Definitions

 

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.  

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.

The yield on a security is the amount of cash (in percentage terms) that returns to the owners of the security, in the form of interest or dividends received from it.

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. 

Indexes are unmanaged, do not reflect deduction of fees and expenses and are not available for direct investment. 

This material is the copyright © 2021 of Lord, Abbett & Co. LLC. All Rights Reserved. 

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