Is inflation on the way? Lauren and Robert discuss the drivers of higher prices and how the Federal Reserve will – or will not – react to inflationary pressures this year. They are joined by fixed income expert Adam Schrier, who describes an investment idea he calls “defending against duration.”
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LAUREN GOODWIN: Investors expecting inflation are starting to sound like the boy who cried wolf. But is inflation just around the corner? Here’s what matters.
LAUREN: Live from our respective coronavirus social distancing outposts, I’m Lauren Goodwin.
ROBERT SERENBETZ: And I’m Robert Serenbetz
LAUREN: and this is Market Matters from New York Life Investments.
ROBERT: In this podcast, we the strategists at New York Life Investments will share insights from the Multi Asset Solutions team: what we think matters as we manage investment solutions.
LAUREN: That includes Mainstays’ diversified portfolio series, including the Income Builder fund, as well as bespoke solutions for our partners.
ROBERT: By sharing perspectives and engaging with you – our listeners – we can all become better investors.
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LAUREN: Welcome everybody, it’s the week of January 25, 2021, and today we are going to talk about inflation and interest rates.
ROBERT: Inflation? Interest rates? I thought that investors had closed the book on those. “Lower for longer”…. More like “low for forever, right?”
LAUREN: Well, that’s the $7.3 trillion question.
ROBERT: Why $7.3 trillion?
LAUREN: It’s the size of the Fed’s balance sheet. I figured it’s as good a number as any.
ROBERT: Oh, ha-ha, I like that. It’s also very relevant to the threat of inflation. A lot of investors hear about the growing fed balance sheet and huge governments deficits and think – hey inflation might just be around the corner!
LAUREN: Meanwhile other investors point out that economists and investors - and the Fed – have been calling for higher inflation for the last 10+ years, to no avail.
ROBERT: I truly can’t think of a more polarizing financial topic these days – maybe value vs growth.
LAUREN: Well, let’s start with real-life inflation, because I want to be clear about that first. We don’t expect yours and my life to feel a ton different because of rising prices in the next few years.
ROBERT: Shoutout to one of our listeners, Lisa from Fort Worth, Texas, who raised this very question this week.
LAUREN: We might see higher prices for some things from time to time. Higher gas prices as economic activity picks up, for example. Or higher restaurant prices as travel and togetherness return.
ROBERT: I can’t wait. But there were also be some other areas where prices are depressed, such as rents, which make up about a third of consumer prices.
LAUREN: Exactly. So, on the whole, I am not worried about inflation this year – or at least the kind that the Fed is going to react to. But that doesn’t mean markets will be quite so calm about inflationary pressures as they emerge. In fact, I think an inflation scare is probably the most likely market risk this year.
ROBERT: That all sounds pretty reasonable, so why are so many investors worried about inflation? And don’t even get me started on interest rates. We’ve been talking about “lower for longer” rates for years.
LAUREN: The answer to that question actually starts with the market rotation idea that you covered last week.
ROBERT: Our regular listeners will remember that rotation is idea that, as economic growth improves, more companies enjoy better profitability. That also typically means that a bigger group of companies show improving market returns. In other words: a rising economic tide tends to raise all ships.
LAUREN: Better economic growth, better company performance, a better environment for consumers… that means things start to chug back to life. And a part of that process is higher demand, Companies tend to raise prices in that type of environment so that they can pay workers more and improve their profitability.
ROBERT: And there it is: inflation.
LAUREN: Exactly: inflation.
ROBERT: But everything we just said is good, right? Why is inflation then the biggest risk this year?
LAUREN: This isn’t about real world prices and it isn’t about wheelbarrows of money. The central reason investors watch inflation is because of its influence on the U.S. Federal Reserve. The Fed has provided swift and sizable support for capital markets over the course of 2020, and investors are understandably concerned about what will happen if that liquidity support fades.
ROBERT: Nobody likes less support, and the markets have gotten accustomed to quite a bit of it in 2020. What’s the expected reaction, then? A taper tantrum?
LAUREN: Yes. In 2013, when the Fed announced that it was going to one day maybe slightly pull back on its policy support after the Financial Crisis, financial markets freaked out a bit. This contributed to a stronger U.S. dollar, lower energy prices, and a manufacturing recession.
ROBERT: I imagine the Fed will really want to avoid that outcome this time around and is already thinking about how to communicate any changes. But this all feels a little early, right? Yes, we could see moments of higher inflation this year, but that’s due in large part to technical factors such as base effects and supply chain constraints. The inflation that the Fed is worried about still seems elusive. If the economy is still shedding 1 million jobs in a week, as we saw in last week’s unemployment claims data… are markets really worried about closing that gap and overheating this year?
LAUREN: As crazy as it sounds, it’s a credible threat in 2021… not a likely threat, but a credible threat. If everything goes right – vaccine distribution accelerates, fiscal support proves sufficient or even overkill, and the economy churns back to life – inflation could move durably higher. If that’s the case, the Fed will start to reconsider its mix of policy support.
But the bar for a Fed response is very high. Inflation would not only need to rise; it also would need to reach and even pass the Fed’s 2.0% target. The Fed would have to be confident that those inflationary pressures would last. The labor market would have to move back towards maximum employment. Even with the strong economic tailwinds we expect for 2021, this would be a lot of progress to expect in one year.
ROBERT: So, you’d join the market consensus and say that this is more of a 2022 risk.
LAUREN: Correct. But look – investors are already asking these questions, which means the market is likely to show signs of jitters even before the Fed makes any hints. Investors should expect rates and even equity market volatility this year as moments of higher-than-expected inflation and a steepening curve raise fears of a Fed drawback.
ROBERT: Given the sheer scale of policy support – not just Fed support but also incoming fiscal support – market drawbacks are likely to be short-lived. The name of the game here will be to find assets that are attractively valued, serving as both an inflation hedge that can also hold up if expectations for growth are not met
LAUREN: It’s time for our portfolio pause, a segment of the podcast where we discuss an investment idea. And whenever inflation enters the picture, the biggest market implication is for interest rates. Higher inflation… higher rates. And for today’s portfolio pause we wanted to go straight to the source on all things investment and interest rates, so we invited a New York Life Investments colleague and fixed income expert, Adam Schrier. Adam, welcome to the program!
ADAM SCHRIER: Thanks for having me. I’m a big fan of the podcast. 😉
LAUREN: You just heard that we are more or less in the consensus camp on interest rates this year. We may see moments of higher inflation and a steeper curve… but they’re likely to be brief. We don’t expect U.S. treasury rates to move substantially higher over the course of 2021. The factors contributing to the “lower for longer” rates environment are still very much intact, and the related global search for yield is likely to mean plenty of demand for U.S. duration assets. Our portfolios are positioned neutral in duration. What is your perspective?
ADAM: Market performance is all about expectations. Even if you’re right and curve-steepening moments are brief this year, they’ll still be raising serious questions for asset allocation.
Most important: investors will be reconsidering their bond portfolios in 2021. And they will consider that credit spreads are not far off from post financial crisis tights and yields are near historic lows. I don’t say this to scare anyone – in fact – credit metrics are improving and defaults are expected to be “normal” this year. I say this more because of the other risk – interest rate risk. Given lower yields and tighter spreads, I believe asset classes are more exposed to rate moves. We’ve seen it already in 2021. Earlier this month the 10 year increased 20 bps and the Agg was down over 1%
LAUREN: What’s the big picture for how that plays out in investment strategy?
ADAM: One of the parts of my job is to look at model portfolios of financial advisors and make recommendations. To see if any of our products make sense for the advisor and their clients. Often I will see multiple fixed income funds, but they have similar asset allocations and are all in the same category. So maybe there are 3-4 funds that all have durations of 6+ years and fairly similar exposures. There is an opportunity there to shorten duration – but do it in a manner that introduces less correlated asset classes, like floating rate loans or short duration high yield. This reduces the overall interest rate risk of the portfolio, and also may increase income.
LAUREN: What’s your favorite trade for this environment? Typically, when inflation is rising, investors can consider cyclical asset classes such as bank loans, short duration, and high yield. Inflation-linked bonds are another option, offering a direct inflation hedge, but also benefiting if real rates – yield minus inflation – fall.
ADAM: Those are all good options for investors – my favorite idea since Q4 of last year has been bank loans. Also known as leveraged loans or floating rate loans. I call it “defending against duration” and it is a bit of an unconventional idea – floating rate loans are typically in favor when the Fed is hiking rates, because floating rate loan coupons increase with those hikes. And you see it in the flow data – the flows are very cyclical and coincide with the Fed.
So this idea about defending against duration is that it is just as important to play defense when longer term rates are rising as it is to play offense to participate in Fed hikes. As we discussed, longer duration assets, which have performed very well in 2019 -2020, are susceptible to small increases in longer term rates. It doesn’t have to be a dramatic steepening where you see the 10 year jump 100 bps. By carving out of a piece of a core bond allocation into floating rate loans, a portfolio will be impacted less if the 10 year increases and at the same time, may earn a higher yield.
LAUREN: These ideas are a lot of fun, but we are admittedly talking about a highly uncertain environment – both in terms of the development itself and the timing upon which it could happen. Any thoughts for investors on how to manage that risk?
ADAM: In absolute terms we are in a low rate environment so dialing up risk for modest increases in yield or total return potential may not be prudent. There are some environments when adding risk can lead to significant increases in returns but I’m not sure this is one of them. When you look at the spread between B rated bonds and CCC rated bonds, which is the incremental yield you earn from moving from the middle of the HY market to the lowest part, it was 272 bps at year end. The 20 year average is over 600 bps. Right around the lowest its been. This means that you simply are not getting paid much to step down in risk. With fixed income, and really any asset class, its important to not just look at returns in isolation, but look at the context of those returns.
LAUREN: Adam, this has been so informative. Thank you for sharing your perspective.
ADAM: Thanks for the conversation.
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LAUREN: Coming up next – and just in time! – it’s Fed week. As we’ve discussed today, all eyes are on the Fed and its support of the economy in the coming months. But remember, we are still in an economic crisis. The labor market is still shedding jobs. It’ll be a while before Fed meetings get really exciting… even if I always think they’re exciting.
ROBERT: Its earnings season. So far we’ve heard from only a handful of companies, but the results have been pretty positive. Banks are guiding expectations higher for the year as they are telling investors that they won’t need to use as many loan losses provisions thanks to all that support we talked about. after just 5% of companies reported, the quarter's expected growth rate improved from -10.3% to -7.8%. This expected growth rate remains well below the estimates before the pandemic but is moving in the right direction.
LAUREN: That’s it for today. We’ll be back next week for more Market Matters.
ROBERT: Let us know what matters to you.
LAUREN: If you have a question or topic of interest, reach out to us on social media.
ROBERT: That’s right. You can send us your questions or highlight what matters to you by finding us on LinkedIn. You can also follow our views on our *new* website at newyorklifeinvestments.com and clicking “insights”. Until then, I’m Robert Serenbetz.
LAUREN: And I’m Lauren Goodwin. See you next time.
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