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Market View

Here, we spotlight a strategy that may help investors counter inflation’s negative effects without undue interest-rate risk.

 

In Brief

  • While U.S. inflation has remained fairly restrained, recent signs of accelerating U.S. wage growth have kept the prospect of a notable uptick in inflation on investors’ radar.
  • This is an important development to monitor, as even a modest rate of inflation can erode the value of investment portfolios significantly over time.
  • Investors should weigh inflation-protection strategies carefully. For example, U.S. Treasury inflation-protected securities come with significant interest-rate exposure.
  • By contrast, managed swaps tied to the U.S. consumer price index may provide the level of inflation protection investors desire without unwelcome duration exposure.
     

Over the course of the past year, Market View has periodically checked in on inflation. The story so far: The U.S. economy has benefitted from an environment of positive economic growth, while inflation has remained contained. 

But one reason we’ve been keeping an eye on the topic is the strength of the U.S. labor market. Some recent indicators suggest that wage pressure could be a potential threat to the current U.S. paradigm of strong growth with low inflation. In a recent Economic Insights, Lord Abbett Partner and Director of Strategic Asset Allocation Giulio Martini highlighted data showing that the pace of U.S. wage growth was quickening (see Chart 1).
 

Chart 1. U.S. Wage Growth Has Begun to Accelerate
Average hourly earnings for designated categories, March 2007–August 2018

Source: Bloomberg and Lord Abbett.
 

To be sure, wages are only one part of the inflation story. The U.S. consumer price index (CPI) rose at a 2.7% annual rate in August, 2018, down slightly from the 2.9% pace in July, according to the U.S. Bureau of Labor Statistics. Another key inflation measure, the U.S. producer price index, posted a small drop in August.  

But while there is as of yet no sign of runaway inflation, even a modest rise in the prices of goods and services can prove harmful. Inflation has been called “the silent thief” because of its tendency to slowly, but steadily erode purchasing power over the longer term.  For example, while inflation at 2% or 3% might not sound like much in the short term, the effect on the value of a dollar over time can be quite significant, as Chart 2 illustrates.
 

Chart 2. Steady and Stealthy: How Inflation Eats Away at Wealth
Changes in the purchasing power of one dollar today over the indicated periods, based on hypothetical long-term inflation rates

Source: Lord Abbett. For the purposes of this chart, purchasing power refers to the value of goods and services that can be purchased with one U.S. dollar. The hypothetical illustrations using 2%, 3%, and 4% rates of inflation are to show the effects of inflation over time; actual inflation rates may be greater or lesser. Inflation is typically measured by changes in the consumer price index maintained by the U.S. Bureau of Labor Statistics.
 

For example, even a 3.0% inflation rate over the course of a decade would diminish the purchasing power of a dollar to the equivalent of only 74 cents.  Over two decades, the value of a dollar would be reduced by nearly one-half. This simple fact may be a powerful inducement for investors to consider an allocation to some form of inflation protection at all times.

But as we have noted in the past, not all forms of inflation protection are created equal. This is where another threat to investors’ portfolios—rising interest rates—becomes a consideration, especially for those with large fixed-income allocations. In seeking inflation protection with the most popular strategy, Treasury inflation-protected securities (TIPS), investors may be taking on an unwelcome degree of interest-rate risk. In fact, the largest exchange-traded fund (ETF) that tracks the TIPS Index now has an effective duration of 7.5 years.

One alternative strategy investors might consider employs a portfolio of professionally managed swaps tied to the CPI. By capturing movements in inflation expectations and changes in headline CPI, the value of CPI swaps is more directly targeted toward inflation, without the interest-rate exposure of a traditional TIPS strategy. [Note: Both CPI swaps and the CPI adjustment for TIPS are based on headline CPI, which includes food and energy, not the core CPI measurement.] Unlike TIPS, CPI swaps historically have a negative correlation with the broader bond market (see Chart 2), which may lead to more efficient diversification for investors’ fixed-income holdings.  For those looking for inflation protection to offset the duration risk in their fixed income portfolios, TIPS might not provide the diversification that investors need, given this high correlation.

 

Chart 3. TIPS Are Highly Correlated with Core Bonds. CPI Swaps Are Not
Correlation with the Bloomberg Barclays U.S. Aggregate Bond Index, as of August 31, 2018   

Source: Morningstar and Bloomberg.
CPI swaps represented by the Bloomberg Inflation Swap USD 5-Year Zero Coupon Index. U.S. TIPS (Treasury inflation-protected securities) are represented by the Bloomberg Barclays U.S. TIPS Index.
With CPI swaps, TIPS, or as with any other securities, investors should remember that past performance is not a reliable indicator or guarantee of future results. 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. Diversification does not ensure a profit or protect against a loss in a declining market.

 

Summing Up
Even at modest rates, inflation carries the potential to erode the value of fixed-income portfolios over time. In seeking strategies to protect against inflation, investors should carefully weigh the potential benefits and drawbacks of each approach. We believe that a managed portfolio employing short-term, credit-sensitive bonds with an overlay of CPI swaps offers the potential to provide higher yield—and lower duration—than a traditional TIPS strategy, while providing an effective level of inflation protection. 
 

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  Market View

CONTRIBUTING STRATEGIST

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The Lord Abbett Inflation Focused Fund seeks to deliver total returns that exceed the rate of inflation in the U.S. over a full inflation cycle. Learn more.
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