Muscle Memory

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by: Neuberger Berman

By Erik Knutzen

Is your portfolio in the right shape to withstand rising prices and rates?

Inflation, and all that it implies about rising interest rates, was stalking financial markets in January. And like any animal being stalked, they got jittery and did unpredictable things.

The U.S. breakeven inflation rate - the difference between the yields on Treasury Inflation Protected Securities (TIPS) and nominal bonds -rose from 180 basis points to more than 200 in January alone. U.S. Treasuries endured their worst month in over a year and kept on tumbling even when equities sold off last week.

The market should have been ready for this. The price of oil rose almost 90% during 2016 and 2017. Prices for China's manufacturers rose dramatically last year. The U.S. output gap has closed, we have been creating jobs for eight straight years, and while average wages appear stagnant, the lower-paid saw their wages grow by more than 3% in 2017. On Friday, average hourly earnings growth came in well above expectations.

In short, the balance of probabilities favors a more inflationary regime in 2018. The Federal Reserve recognized that last week, as did the audience at our "Solving for 2018" conference in London, which identified inflation and rising rates as the biggest risk for the year. It was explicit and implicit in the views set out in our most recent Asset Allocation Committee (AAC) Outlook.

We have had five years of below-target inflation and depressed bond yields, however. Many market participants have never experienced sustained inflation above 3% in the developed world. Investors may have lost the "muscle memory" of how to position in this kind of environment - and when you're being stalked, muscle memory is everything.

The Underlying Trend

Right now, inflation is still a mere rustling in the undergrowth. With the exception of France, last week's consumer price inflation prints out of the eurozone were softer than hoped, for example. There are also structural forces weighing on inflation - as Joe Amato put it at our recent "Solving for 2018" conference in London, Walmart (NYSE:WMT) is a huge employer with a rising wage bill, but it's unlikely to jack up prices as long as it's battling Amazon for the consumer's dollar.

Nonetheless, we think the underlying trend is unmistakable, and it is meaningful for the majority of investors who have liabilities that rise with inflation or who want to preserve the purchasing power of their assets. Even those focused purely on asset returns should remember that some investments have tended to perform well when prices are rising and some perform very poorly.

Mitigating the Downside, Capturing the Upside

Our last AAC Outlook discussed some ideas on how to get portfolios back into shape.

One of the most important things to consider is a portfolio's interest-rate sensitivity or "duration." Investors with long duration might consider shortening it, and investors who would currently benefit from a flattening yield curve could position portfolios for something steeper. Inflationary pressures on interest rates could lead to the kind of wider market volatility we got a taste of last week, so it might make sense to consider adopting lower risk exposures in equity and credit as the year progresses.

That could help mitigate downside risk. To still allow for upside capture, investors might want to consider replacing some nominal bonds with global inflation-linked bonds, including TIPS, which still offer attractive real yields, in our view. Commodities and energy-sector equities have also tended to benefit when prices are rising, not least because commodities feed into many of those prices.

There are a lot of commodity producers in the emerging markets. It is also true that the emerging world has generally benefited most from an environment of rising trade, growth and global inflation. Emerging markets debt, equities and currencies can be important components of an inflation-sensitive portfolio, and are still available at relatively attractive valuations.

Much of this will sound familiar. These assets have been out of favor for a while, but when inflation was relatively high in the emerging world and on target in the developed world, they were part of many portfolios. We think investors may want to recover that muscle memory: January's jitters may have been telling us that we are entering an environment in which inflation may run above target, and interest rates go up rather than down.

In Case You Missed It

  • U.S. Personal Income and Outlays: Personal spending increased 0.4%, income increased 0.4%, and the savings rate decreased to 2.4% in December
  • S&P Case-Shiller HPI: November home prices increased 0.2% month-over-month and increased 6.4% year-over-year (NSA); +0.7% month-over-month (SA)
  • Eurozone 4Q17 GDP (first estimate): +2.7% annualized rate
  • FOMC Minutes: The FOMC made no changes to its policy stance
  • ISM Manufacturing Index: -0.2 to 59.1 in January
  • U.S. Employment Report: Nonfarm payrolls increased 200,000 and the unemployment rate declined to 4.1% in December

What to Watch For

  • Monday, 2/5:
    • ISM Non-Manufacturing Index
    • Eurozone Purchasing Manufacturing Index
    • U.S. Purchasing Manufacturing Index

- Andrew White, Investment Strategy Group

Statistics on the Current State of the Market - as of February 2, 2018

Market Index WTD MTD YTD
Equity
S&P 500 Index -3.8% -2.2% 3.4%
Russell 1000 Index -3.8% -2.1% 3.3%
Russell 1000 Growth Index -3.7% -2.3% 4.6%
Russell 1000 Value Index -3.8% -1.9% 1.9%
Russell 2000 Index -3.8% -1.8% 0.8%
MSCI World Index -3.4% -1.9% 3.3%
MSCI EAFE Index -2.7% -1.3% 3.6%
MSCI Emerging Markets Index -3.3% -1.9% 6.3%
STOXX Europe 600 -3.1% -2.0% 3.4%
FTSE 100 Index -2.9% -1.2% -3.1%
TOPIX -0.8% 1.5% 2.6%
CSI 300 Index -2.5% -0.1% 6.0%
Fixed Income & Currency
Citigroup 2-Year Treasury Index 0.0% 0.0% -0.3%
Citigroup 10-Year Treasury Index -1.6% -1.2% -3.6%
Bloomberg Barclays Municipal Bond Index -1.0% -0.4% -1.6%
Bloomberg Barclays US Aggregate Bond Index -0.9% -0.7% -1.8%
Bloomberg Barclays Global Aggregate Index -0.9% -0.7% 0.5%
S&P/LSTA U.S. Leveraged Loan 100 Index 0.2% 0.1% 1.1%
ICE BofA Merrill Lynch U.S. High Yield Index -0.7% -0.5% 0.2%
ICE BofA Merrill Lynch Global High Yield Index -0.6% -0.4% 1.0%
JP Morgan EMBI Global Diversified Index -0.8% -0.6% -0.6%
JP Morgan GBI-EM Global Diversified Index -0.7% -0.5% 4.0%
U.S. Dollar per British Pounds -0.4% -0.7% 4.4%
U.S. Dollar per Euro 0.0% -0.2% 3.6%
U.S. Dollar per Japanese Yen -1.6% -1.1% 2.1%
Real & Alternative Assets
Alerian MLP Index -5.9% -2.1% 3.5%
FTSE EPRA/NAREIT North America Index -3.3% -3.0% -6.7%
FTSE EPRA/NAREIT Global Index -3.1% -2.3% -1.0%
Bloomberg Commodity Index -1.8% -0.7% 1.2%
Gold (NYM $/ozt) Continuous Future -1.1% -0.4% 2.1%
Crude Oil (NYM $/bbl) Continuous Future -1.0% 1.1% 8.3%

Source: FactSet, Neuberger Berman.

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