Every investor should consider the impact of the current rising inflation rate and future inflation rate expectations on the value of his or her income generating securities.
Increasing inflation, or even the projection that inflation will increase, will make income-generating securities less attractive than during periods of low and steady rates of inflation.
The main reason is: while inflation is rising, investors demand more and more income from their investments in equities and bonds to compensate for the higher costs of goods and services purchased. Putting it differently, investors demand more payment (yield) to put their capital at risk, especially in interest-rate-sensitive equities. When the pace of inflation quickens, investors demand even more yield to take risk because they are not sure how high inflation will go.
How do we know for sure that investors demand more payment (yield) for their invested capital when inflation is on the rise? The U.S. 10-Year Treasury Yield is a widely accepted measure of the amount of payment, (i.e. percentage return on invested capital), demanded to lock up money for 10 years.
Let us take a look at a historical correlation between inflation and 10-Year Treasury Yields along with the Federal Funds Rate.
In the graph below we can see the green bars of the histogram and we can also see the red line (Federal Funds Rate) and the blue line which is the 10-Year Treasury Yield weekly average. Although it is not a perfect 1:1 correlation, I would say it is a high correlation.
Source: Advisor Perspectives.
Let us take a short-term viewpoint: In the graph below we can see a high correlation. Notice the quickening pace of the U.S. 10-Year Treasury yield since the mid-November elections. Inflation expectations are rising with the notion that upcoming fiscal policy by the Trump administration will be inflationary.
So far we have seen the high correlation between inflation, increasing Federal Funds Rate and U.S. 10-Year Treasury Yields.
Let us take a look at annual inflation since 1989 to see if we can make a projection on whether or not we can expect inflation to rise in the future.
Interpretation: The black line is the annual inflation rate and it seems to be heading towards the 2% Fed target. The black line is rising so that means, inflation is rising. The red 12-month moving average is pointing up so that means we are in an inflationary stance. Looking at the trajectory of those two lines, it does appear deflation is less and less a concern. Also note the dip into deflation (-0.20) in 2015. In early 2015, the market began to struggle as investors took note. Perhaps this chart can be seen as somewhat of a leading indicator for the path of interest rates?
As we can also see from the graph, the inflation rate is heading towards the Fed's 2% target. The rise up to the 2% target is not of grave concern, but a significant rise above 2% would be noticed.
Now a well-informed investor, who looks at this annual inflation rate graph and is following marketplace news, should conclude that inflation is heading higher in the short term. Remember we have established the fact that 10-Year Treasury Yields are correlated to inflation expectations, therefore we can expect higher yields on U.S. Treasuries. And indeed, currently, we are seeing higher yields!
Now let us take a look at "the pace" of rising yields on 30-Year U.S. Treasury Bonds:
The 30-Year U.S. Treasury Bond is considered the most sensitive to increasing inflation pressures because of its long duration. Investors who are unsure about future inflation rates begin to demand a higher yield to 'lock up' money for 30 years. We can see from the above chart that investors are in fact demanding more yield since July 2016. What also must be noted is the sharp increase since July 8, 2016, when the yield was 2.098%. Yield has increased 44% in 4 1/2 months' (!) time to 3.02%. Hence, investors are demanding 44% more payment for invested capital because they see inflation in the future. Will this pace of increase continue?
Whenever I am doing any analysis, I am highly interested in what other analysts and investors think. I do this to determine whether or not others agree with my thinking. I want my analysis and thinking to be aligned with professional money managers and astute investors.
Here is what some professional fund managers think about inflation:
The November survey of global fund managers conducted by Bank of America Merrill Lynch between Nov. 9, the day after the election, and Nov. 14, found that a net 85% of respondents expect global inflation to rise versus 70% in October - the highest since June 2004.
Let's see what some professional fund managers think about a steepening yield curve (higher interest rates) - an indicator of inflation.
"Hand in hand with rising inflation expectations, the survey found that a net 65% of investors now expect the yield curve - the differential between short- and longer-dated yields - to steepen over the next 12 months. That's up from 31% in October and marks the biggest monthly jump on record," Bank of America said.
Let us examine some of the reasons why investors begin to evaluate and maybe even 'rotate away' from income generating equities and fixed income instruments during rising inflation.
The graph below does illustrate the impact on what are generally considered: interest-rate-sensitive securities.
I own 5 stocks (bond surrogates) in the above graph and measured their interest rate sensitivity to the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) to examine the correlation. I can see that the correlation is not exactly 1:1, but it is considered high.
This leads me to the expectation: should TLT be repriced lower (yield rising) that the market will reprice these securities of mine lower with a corresponding higher yield. I am using a 6-month time-frame, since during mid-summer, inflation and interest rate expectations began to change.
Below we can see the sensitivity to rising interest rates on a sector wide basis. I am using a 6-month time-frame, since during mid-summer, inflation and interest rate expectations began to change.
Defensive Sector ETFs:
The securities in the above illustrations are not being singled out as bad investments, or to say, they should be sold, but that the market is in a mode of repricing these assets, amongst others, based on inflation and rising interest rate expectations.
In fact, many investors will be making new investments at these levels because of a certain amount of goodness in them, e.g. low relative volatility, investment grade, safety of capital, safety of dividend, acceptable dividend yield with respect to risk taken, etc.
Also, it would be my expectation that should inflation and interest rate pressures subside in the coming months, that these assets would be repriced accordingly.
The impact of higher inflation and rising interest rates does, however, have a positive effect on portfolio values that can offset the negative effects of interest-rate-sensitive securities.
Many yield-starved investors have accumulated income sensitive securities over the past several years without thought given to what they would do should interest rates rise sharply. In other words, they have not planned a hedge.
Take a look at the performance of the following securities. These securities are generally considered to be investments in economically cyclical industries. These securities would be considered a good hedge against interest rates rising given a good economic backdrop.
Again, I am using a 6-month time-frame because around mid-summer inflation and interest rate expectations began to change.
This article is not intended to be an academic study of inflation, interest rates and their correlations to income generating equities and fixed income instruments. But it is intended to raise awareness to the practical effects of higher inflation and interest rates on an investor's portfolio. There are many qualified S A contributors who can add even more 'color' to this exercise I have undertaken.
This article is not intended as a call to sell defensive sector assets at this time, but to be mindful of the impacts of inflation and higher interest rates on the defensive sectors including interest rate sensitive REITS & MLPs.
I am not yet convinced that the pace of higher inflation and interest rates to date is enough to greatly impact income generating equities, but investors should be closely tracking the monthly inflation rate (Consumer Price Index) and (daily) treasury yields for notable increases.
Stronger economic growth, higher inflation expectations and higher interest rates (U.S. Treasury Bond yields) will affect many income generating instruments as I have shown. The defensive sectors of the market: Utilities, Telecom Services, Consumer Staples, Healthcare will most likely underperform because of higher interest rates and bonds becoming a more attractive alternative again.
On the other hand, Financials, Industrials, Materials, Technology, Energy, Consumer Discretionary should experience a period of performance over the defensive sectors.
Keep in mind, economic and inflation data can weaken at any time going forward and countervail rising bond yields; should that occur, I would expect interest-rate-sensitive securities and defensive sectors to perform accordingly; evermore the reason to ensure portfolio diversification!
In addition to monitoring both inflation and treasury rates, an investor should be mindful of portfolio allocation to income generating equities and fixed income instruments. More to the point, an investor should perform a portfolio inspection and be aware of the percentage of assets that are considered defensive and interest rate sensitive.
With this awareness an investor should be in a position to decide whether to rotate into more economically sensitive (cyclical) equities to capture overall portfolio gains, should inflation and interest rates rise, or merely maintain an appropriate allocation to income-sensitive securities. Investors should always maintain a diversified portfolio with exposure to many sectors and asset types to dampen the effects of rising inflation and interest rate expectations.
Disclosure: I am/we are long PPL, VZ, PFE, PM, WPC, XLF, JPM, XLI, ITA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: This article is informational. I have no knowledge of individual investor circumstances, goals, portfolio diversification, etc., readers are expected to complete their own due diligence before making investments.