Produced by The Belgian Dentist for The Income Strategist
Over the last couple of weeks, we have published several articles on highly contrarian strategies. When Investor Sentiment is Too Bullish on REITs, Look For Weakness has so far been crushed by the shift toward more defensive sectors, with real estate joining utilities and consumer staples as leaders. We also suggested taking a look at higher-risk REITs vs. lower-yielding safer REITs in our article To Play It Safe or Not: A Comparison of 2 REIT ETFs. We concluded that the higher-risk, higher-return ETF was undervalued relative to the lower-risk, lower-yield ETF and that the gap in valuation was now worth shifting toward the former. Again, the risk-off sentiment has caused that valuation gap to widen further, and our conviction for a reversal is now even higher.
I also introduced several ideas in Income Strategies for an Inverted Yield Curve. Honestly, the article was much more popular than I expected, and it too introduces ideas that have been beaten up as of late.
We realize these contrarian strategies are not for the faint at heart, and sometimes, the consensus view continues to be the better performing strategy, until it isn't - and it usually reverses pretty quickly. In fact, the expectations of rising rates have been quickly replaced by expectations of a rate cut, and it's these types of shifts in market sentiment that drive us at The Income Strategist to make sure we look at both sides of the coin - so to speak.
With the economy showing signs of slowing - pick your reason here - inflation expectations have declined, and the Fed is now more likely to cut rates than raise them - at least that is the consensus view. We agree with that view, but also note that when the Fed cuts rates, part of the intended effect is to increase inflation. But before inflation actually increases, inflation expectations increase - and it is this sentiment we want to try to catch early.
The Best Investment Solution For Higher Inflation Expectations
We provide broad and detailed coverage on a variety of income producing investments. And in an environment where rates are expected to decline, that is a solid strategy - especially if rates do decline. However, as a portfolio manager, I'm also very cautious about putting too many eggs in one basket, and just because I have multiple REITs, MLPs, BDCs, Preferred stocks, Bonds, and dividend growth stocks in my portfolio does NOT mean I'm properly diversified.
While the underlying stocks provide diversification if their correlation is anything less than zero, the fact is that all of these asset classes may be similarly affected by changes in rates and changes in inflation expectations. So, be mindful of this and consider ways to really diversify your portfolio in the event the direction of interest rates and inflation surprises us to the upside.
The best investment solution for higher inflation expectations
The consensus: Economic growth is low, inflation expectations are low, and the Fed will cut rates as a consequence. What if consensus is wrong, however?
Is there a case for higher inflation? And if consensus is wrong, you certainly don't want to be caught with your pants down or go scrambling for what to do. Here's an idea to put on your radar for that day.
Inflation and Expectations
U.S. inflation is subdued. Persistently subdued inflation works to lower inflation expectations as well as increase the confidence that inflation risk will remain low for an extended period of time. What this means is that the spread between the U.S. 10-year Treasury yield and the historical core (excluding food and energy) inflation rate tends to narrow as more and more market participants accept the narrative that inflation will remain subdued for a long time.
Exhibit 1: US PCE Inflation Excluding Food and Energy
Not long ago, investors were agnostic about inflation whether the narrative was for higher or lower inflation. However, the Fed publishes option market-based estimates of the probabilities of rising or declining inflation expectations, and it does seem that investors are now more worried about a large decrease in inflation than a large increase in inflation.
Exhibit 2: Option market based inflation probabilities
This puts pressure on the Fed to lower interest rates, which has been the headline over the last several months and has intensified in the last few weeks.
The Fed funds futures market now puts the chance of at least one rate cut this year at 97.4%, according to the CME FedWatch Tool. Three months ago, the chance was virtually zero.
Exhibit 3: Target rate probabilities
The probability of five rate cuts (assuming that one rate cut equals 25 basis points) by the December Fed meeting is 2.1%. The probability of four, three and two rate cuts by the December Fed meeting is 16.5%, 49.1% and 82.1%, respectively. And the probability of at least one rate cut by the end of the year is 97.4%!
These probabilities only reinforce the general feeling of lower growth and low(er) inflation.
The case for continued low(er) inflation
In the past few years, inflation rates have persistently been below central banks’ goals. The fact that inflation has been running below target in most advanced countries suggests that this challenge is not due to factors specific to a single country, according to New York Fed Bank President John C. Williams. Instead, there are more systemic factors at play.
Investors view these low inflation readings not as an aberration, but rather a new normal. This is evidenced by a broad-based decline in market-based measures of longer-run inflation expectations since the mid-2000s, with the UK again providing the exception.
Exhibit 4: Market-implied inflation expectations
This experience of slow recovery and persistently low inflation is a symptom of a deeper problem afflicting advanced economies. Underlying these events has been a sea change in the supply side of economies, owing to fundamental shifts in demographics and productivity growth.
Two demographic trends are evident: People are generally living longer and population growth is slowing. Overall life expectancy in member countries of the OECD has increased from about 65 years in the 1950s to nearly 80 years today and is projected to exceed 90 years by the end of this century. Despite this increase in longevity, dwindling birth rates are bringing population growth to a standstill.
Exhibit 5: Demographics
When it comes to productivity, the changes are no less dramatic. In OECD economies, growth in labor productivity - the amount produced per worker hour - has averaged a little over 1 percent per year since 2005, about half the pace seen over the prior decade. A major factor driving the slowdown is a dramatic decline in the growth rate of “total factor productivity,” or TFP, a measure of innovation and technological change.
Exhibit 6: Productivity growth slowdown
U.S. productivity growth tends to cycle between periods of high growth in decades following fundamental breakthroughs in science and technology, and relatively fallow periods of steady, incremental improvements. The evidence indicates that we are in one of the latter periods of “normal” productivity growth of 1-1.5 percent per year, and that things will likely stay that way until the next scientific or technological revolution.
These shifts in demographics and productivity translate directly into slower trend economic growth. Slower trend growth reduces the demand for investment, while longer life expectancy tends to increase household saving. All of this leads to low economic growth and low inflation.
There are several other reasons that inflation has been subdued since the mid 1990s. First, prudent regulation has increasingly focused on mitigating systematic financial risk through tight capital requirements for financial enterprises. The result has been that central bank monetary policy, from zero rates to quantitative easing, has limited consumer and business lending, and so economic growth is not stimulated and inflation does not gain traction – only asset prices rise and volatility is dampened. Secondly, the Internet Age has brought amazing transparency to prices. Consumers can comparison shop on their smartphones, and this has shifted pricing power away from businesses and constrained inflation pressures. Third, while the era of globalization may now be going in reverse with the escalating US-China trade war, there's little question that trade growth and globalization has served to keep a lid on consumer prices for decades.
Will those fundamental shifts in demographics and productivity growth remain in place for years to come or is there a case to be made for higher inflation?
The case for high(er) inflation
Mohamed El-Erian, Chief Economic Adviser at Allianz, thinks that after years of low inflation, investors and policymakers have settled into a cyclical mindset that assumes advanced economies are simply suffering from insufficient aggregate demand, caused by shifts in demographics and productivity growth. But he warns they are ignoring structural factors at their peril.
Today’s surprisingly low inflation also appears to be linked to larger structural forces, which means that it’s not rooted only in insufficient aggregate demand. Technological innovations – particularly those related to artificial intelligence, big data, and mobility – have ushered in a more generalized breakdown of traditional economic relationships and an erosion of pricing power.
Taken together, El-Erian calls these structural forces the Amazon/Google/Uber effect. While the Amazon (NASDAQ:AMZN) model pushes down prices by allowing consumers to bypass more expensive intermediaries, Google (NASDAQ:GOOG) (NASDAQ:GOOGL) undercuts companies’ pricing power by reducing search costs, and Uber (NYSE:UBER) brings existing assets into the marketplace, further eroding established firms’ pricing power.
The Amazon/Google/Uber effect has turbocharged a disinflationary process that began with the acceleration of globalization, bringing far more low-cost production online and reducing the power of organized labor in advanced economies (as has the gig economy more recently).
But while these trends will mostly continue for now, they are likely to confront countervailing inflationary influences that have yet to reach critical mass: The slack in the labor market is diminishing every month, and increased industrial concentration is giving some companies, especially in the technology sector, far greater pricing power.
Now, consider those trends in the context of today’s changing political landscape. Fueled by understandable anger over inequality (of income, wealth, and opportunity), more politicians are embracing populism, with promises of more active fiscal management and measures to curb the power of capital in favor of labor. At the same time, there's growing political pressure on central banks to bypass the asset channel (that is, QE bond purchases) and inject liquidity directly into the economy.
Economic anxieties also are driving anti-globalization politics. The weaponization of economic policy tools such as tariffs and other trade measures is risking a fragmentation of global economic and financial relationships, favoring higher prices, and compelling a greater degree of more costly self-insurance by companies and consumers.
Considering how these competing forces are likely to play out over time, policymakers and investors should not rule out a return of inflation over time.
Looking ahead, we will likely continue experiencing an initial stage in which the Amazon/Google/Uber effect remains dominant. But that may well be followed by a second stage in which tight labor markets, populist nationalism, and industry concentration begin to offset the one-time structural effects of new technologies being widely adopted. And, in a third stage, the possible onset of higher inflation may catch policymakers and investors by surprise, producing excessive reactions that make a bad situation worse.
As with most paradigm shifts, there can be little certainty regarding the timing of this scenario. But, either way, policymakers in advanced economies must recognize that their inflation outlook is subject to a wider range of dynamic possibilities than they have considered so far. Focusing too much on the cyclical, rather than the structural, could pose serious risks to future economic well-being and financial stability. The longer we wait to broaden the prevailing mindset, the more likely we are to advance to the next stages of an inflationary process in which the impact of an exciting one-and-done technological event gives way to some old and more familiar tendencies.
El-Erian is clear: Investors should prepare themselves for (the possibility of) higher inflation.
How to play higher inflation expectations
In the advent of a return of inflation, bonds will be in a deep bear market. TIPS will be a better investment than regular bonds, but only on a relative basis.
If future inflation ends up being higher than the breakeven rate, then a TIPS investor will outperform a regular bond investor and vice versa.
Exhibit 7: Treasuries versus TIPS
The breakeven inflation rate is a market-based measure of expected inflation. It's the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity.
The breakeven inflation rate is called that way because you would (roughly) receive the same total return on TIPS as you would a nominal Treasury if CPI inflation averages that level over the next 10 years.
10-year breakeven inflation rate = (10-year nominal Treasury yield) - (10-year TIPS yield).
Exhibit 8: 10-year Treasury rates
Most people refer to the yield on TIPS as being the real yield.
As investors predict less inflation, their demand for TIPS decreases, and the price relative to regular treasuries declines. The “breakeven” rate then declines. That’s why the breakeven inflation rate is called a market-based measure of expected inflation.
Exhibit 9: Breakeven inflation
So, is investing in TIPS really the best available option if you expect rising inflation?
Rising breakeven levels does not necessarily mean the price of TIPS will rise. It only means it will outperform the equivalent Treasury bond.
The problem with TIPS is they are not a simple bet on inflation. TIPS are made up of two portions, which makes their movement through interest rate cycles confusing. There's a direct inflation-linked component, but there's also a fixed income component. The fact that this fixed income component moves in the opposite direction of inflation is what makes profiting on TIPS so difficult.
The TIPS’ price adjusts in response to the increase in inflation, but if the real component of the interest rate (the amount investors demand over inflation) rises, then the TIPS will not rise enough to offset this loss caused by the rising real rate.
So, owning TIPS in an inflationary environment is not a no-brainer win.
Imagine that inflation goes to 3%. And, what if with this 3% inflation the 10-year nominal bonds go to 6%? Well, if breakevens follow actual inflation, that would imply a TIPS yield of 3% also. So, the TIPS yield will have gone from 0.48% to 3%. This will mean a capital loss for investors in TIPS.
For investors who don’t want fixed income exposure per se, but instead want a way to play the breakeven inflation rate, the way to go about it is to buy TIPS and short the regular Treasuries. What you want to do is play the relative outperformance of TIPS versus the regular treasury bond.
But this is easier said than done. You need to match durations and adjust the hedge on a continuous base.
If you're really confused by what you just read, don't worry about going back over it to learn how to do it, there's an ETF that can do this for you...
Inflation expectations ETF
If you expect higher inflation breakeven levels, the best available option is the ProShares Inflation Expectations ETF (RINF).
RINF seeks investment results that track the performance of the FTSE 30-Year TIPS (Treasury Rate-Hedged) Index.
The ProShares Inflation Expectations ETF gives buyers a way to profit from increases in the market’s expectation of inflation. To do so, the fund buys 30-year TIPS and sells a similar amount of duration-adjusted U.S. Treasury bond positions, attempting to achieve an overall effective duration of zero. The fund is rebalanced monthly.
Simeon Hyman, global investment strategist for ProShares, says hedging out the duration risk is key to the fund’s strategy.
Duration is the thing that people forget about with TIPS,” Hyman says. People think, well, I'm going to buy these TIPS and they’re inflation protected, so all is well. But these are still bonds with duration risk and they're subject to the risk of (REAL) interest rates rising. Even if you get some adjustments from changes in expected inflation, you can still lose money with TIPS because overall interest rates go up.
He adds that RINF does best when inflation expectations are rising, not necessarily when inflation rises, which is why it doesn’t reflect the CPI or other inflation measures. The fund's index is designed to be sensitive to changes in breakeven inflation. It is not designed to reflect CPI or other measures of realized inflation.
As you can see in exhibit 10, there isn’t much difference in the 30-year breakeven inflation compared to the 10-year breakeven inflation.
Exhibit 10: 10-year vs. 30-year breakeven inflation
The yield of the ProShares Inflation Expectations ETF is 2.25 percent, and its expense ratio is 30 basis points. RINF has only $8.7 million in assets under management.
Recently, the breakeven inflation has fallen, and if you're a rear-view mirror investor, RINF wouldn't even be on your radar until its way too late. Its performance has mimicked the decline in breakeven inflation.
Exhibit 11: Breakeven inflation
Exhibit 12: ProShares Inflation Expectations ETF
Will breakeven inflation fall further? It’s possible. Will this low inflation regime continue for a while? It’s possible.
Will inflation expectations rise? It’s also quite possible. To quote Mohamed El-Arin:
“And in a third stage, the possible onset of higher inflation may catch policymakers and investors by surprise, producing excessive reactions that make a bad situation worse.”
Be prepared, especially, if like many of our readers, you have a highly fixed income or dividend paying portfolio that is at risk of declining when rates rise. Even REITs, that should do well when inflation is high – based on the expected rise in real estate asset values – often times sell off along with other high dividend paying stocks.
Inflation and inflation expectations are low. Everybody seems to expect this situation will continue. When the consensus overwhelmingly expects something, oftentimes, the opposite happens. And, when the consensus overwhelmingly expects something, people do not prepare themselves for the opposite to happen, making that unexpected outcome much worse. Inflation and inflation expectations could be a case in point.
Investors who want to be prepared for higher inflation expectations or want some protection in their income focused portfolio should certainly consider the ProShares Inflation Expectations ETF. It pays a 2.3% dividend too so at least you're getting some income in the meantime.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances. Furthermore, none of the ideas presented here are necessarily related to NFG Wealth Advisors or any portfolio managed by NFG.