Many investors, having enjoyed the bull market, have a “if it’s not broken, don’t fix it,” mentality when it comes to their portfolios, and therefore haven’t taken a hard look at their portfolios in a while. Of particular concern is the fact that inflation expectations priced into the market are historically low—very, very low. Using the break even spread of U.S. Treasury Inflation Protected Securities (TIPS) vs. nominal U.S. Treasuries, the implied level of inflation for the next 30 years is 1.81% as of 12/31/19. With U.S. Treasuries themselves at historically low levels, fixed income investors have very little protection from any uptick in inflation eating into their already meager real returns.
Fig 6. Rolling Inflation (CPI) Averages (1943—2019)
Source: Federal Reserve Bank of St. Louis and the Bureau of Economic Analysis, Calculated by Arrow.
The Fed’s mandate—to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates—currently targets inflation of 2%. We have been below these levels since the great recession except for some short-lived upticks in 2011 and 2018. The Fed historically has demonstrated that interest rate policy can effectively stabilize the economy as long as inflation is in check. Once inflation takes hold, the Fed is on the defensive and is much less effective. We would expect that sooner or later (later, because it’s already overdue) the tremendous expansion of global monetary supply these past 10 years will create inflation, but it hasn’t yet. More recently, a tight labor market and tariffs could create inflationary pressure (both are inputs into the cost of goods sold).
Fig 7. Historical Averages & Projected Break Even
Source: Federal Reserve Bank of St. Louis and the Bureau of Economic Analysis, Calculated by Arrow.
To place current inflation expectations into context, CPI Urban, the inflation benchmark for TIPS, has historical data back to 1916 (see the CPI Urban YOY% Figure 7). For all 30-year rolling periods, the current break even of 1.81% is at the 16th percentile. Within this data series, the period that had lowest average 30-year inflation was 1945-1960, which has the deflationary period of the great depression skewing the average down. Since 1960, we are at the ZERO percentile. We’re more comfortable basing
our decision-making using history, mindful that the past isn’t the present, rather than “this time it’s different and history is irrelevant.” As recently as 2009 inflation was above 2.5% from 2006—2008 and in 2011.
If inflation were to normalize at the Fed’s target of 2% over the next 30 years, investors in 30-year U.S. Treasuries will have a negative real return of -0.50% annualized. If inflation were to normalize at the median 30-year rolling average of 3.3%, investors in 30-years U.S. treasuries will have a negative real return of -1.30% annualized. Given this risk, we believe that investors should reevaluate their portfolio composition, placing an emphasis on higher-than-expected inflation in the future.
Whether it is measured by consumer prices (as reflected by the Consumer Price Index), or producer prices
(as reflected by the Producer Price Index, or PPI), or raw materials such as commodities, as we’ve outlined above, inflation has been low for several years. Without significant global growth, there really has been a lack of global demand to drive prices higher. For perspective, we looked at historical market environments and how they have changed over the years. The accompanying image shows the history of the U.S. dollar and inflation, as illustrated by the PPI. There are periods where the gap between the two lines widens dramatically and is eventually followed by a reversal in direction for both.
Fig 8. Historical Movements of the U.S. Dollar and Inflation
Past performance is not indicative of future returns. See asset class proxy disclosure. Source: Morningstar and Federal Reserve Economic Data (FRED), calculated by Arrow.
When lower demand is coupled with a strong U.S. dollar, inflation is often kept at bay. The U.S. dollar has been in decline since 2017. This is another signal that with global growth increasing, the environment continues to make a strong case for commodities and investing in the international stock markets in 2020 and beyond.
Many commodities trade in U.S. dollars across global markets.
A declining dollar often helps commodity prices as global investors must pay more for U.S. currency conversion. This is evident in the period following 1999, when commodities rallied on a declining dollar. The opposite happened
in 2009, following the infamous financial crisis of 2008, when the dollar gained comparative global strength and commodities prices suffered. Since 2016, inflation
has been on the rise and the U.S. dollar has weakened. These trends are favorable to real assets such as commodities as well as managed futures strategies, which have the ability to profit from up or down price trends in commodity futures.
Does that spell trouble for the U.S. equity market?
Figure 9 shows the ratio between the GSCI (commodity) Index vs. the S&P 500 (equity). When the ratio is low, it means commodities are cheap relative to equities. Historically, when the ratio dipped below 2 and reversed upward, commodities significantly outperformed the equity market. Historically low, this could also be another precursor to a recession, which usually happens when commodities rally.
Fig 9. Commodities vs. Equities
Past performance is not indicative of future returns. See asset class proxy disclosure. Source: Morningstar, calculated by Arrow.
Fig 10. Rolling Asset Class Performance: Mean Reversion
Past performance is not indicative of future returns. See asset class proxy disclosure. Source: Morningstar, calculated by Arrow.
Figure 10 illustrates the calendar year performance for 11 different asset classes and their historical three-, five- and 10-year averages vs. their current return for the same time frame. This chart illustrates how close the U.S. markets are to their historical average and how far commodities and international markets are from their mean returns. In early 2016, we made a case for a reversion to the mean for commodity prices. After many consecutive years of losses, downtrodden foreign securities, energy, other natural resources, precious metals markets, real estate and other inflation hedge asset classes rebounded strongly in the third quarter of 2017.
Was this a short-term trend or the start of a long-term reversal?
Asset Class Proxy Disclosure:
Past performance does not guarantee future results. Categories display the returns of current funds in the Morningstar category during the time period shown, subject to survivorship and/or re-categorization. Index and strategy research returns assume reinvestment of dividends, but do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and are not available for direct investment.
Asset class proxies (in order as shown above by figure): Figure 8: U.S. Dollar (RTW U.S. Dollar Index), Producer Price Index, Figure 9: U.S. Equity (S&P 500), Commodity (S&P GSCI), Countries (average of 48 investable countries- Argentina, Australia, Austria, Belgium, Brazil, Canada, Chile, China, Colombia, Denmark, Egypt, Finland, France, Germany, Greece, Hong Kong, India, Indonesia, Ireland, Israel, Italy, Japan, Korea, Malaysia, Mexico, Netherlands, New Zealand, Nigeria, Norway, Pakistan, Peru, Philippines, Poland, Portugal, Qatar, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, UAE, United Kingdom and Vietnam), Figure 10: Inflation (IA SBBI U.S. Inflation), 30 Day Tbill (IA SBBI U.S. Treasury Bills), Intermediate Govt Bonds( IA SBBI U.S. Intermediate-Term, Government Bond), Long-Term Govt Bonds (IA SBBI U.S. Long-Term Government Bond), Long-Term Corporate Bonds (IA SBBI Long-Term Corporate Bond), High Yield Corporate Bonds (Barclays U.S. High Yield Corporate Bond), U.S. Large Cap Stocks (S&P 500), U.S. Small Cap Stocks (IA SBBI Small Company Stock, Commodity Markets), (S&P GSCI), International Country Markets (see Fig 17 note below), Real Estate (FTSE NAREIT). |
