Published June 30, 2021
It’s clear that the bond market, and bond investors, are neither preparing for nor panicked about inflation.
It’s clear that the bond market, and bond investors, are neither preparing for nor panicked about inflation.
Will inflation rise? How will the Federal Reserve react? Can it halt the recovery? Questions like these have dominated the financial press so far in 2021. Adviser Investments’ bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. experts, Chris Keith and Jen Yousif, sat down with Charlie Toole to talk about what’s behind those headlines. They discuss:
Understanding how inflation can impact your portfolio is essential for any fixed-income investor. Click above to listen, learn and prepare.
Hello, and welcome to another The Adviser You Can Talk To Podcast. I’m Charlie Toole, a portfolio manager on the research team. And I’m joined by my colleagues, Chris Keith, portfolio manager of our Managed Bond Strategy and Research Analyst Jen Yousif. Chris and Jen, welcome.
Charlie, it’s good to be here with you today. I think we have a pretty good subject that’s certainly receiving a lot of attention in the financial media and beyond lately.
Thanks for having us, Charlie.
That’s right. Thank you, Jen. And you’re right, Chris. Today’s topic is inflation and inflation has dominated the headlines in the financial press and even in the mainstream press over the last several months. And some inflation is good, but if inflation gets out of hand, it can eat away at purchasing power and certainly hurt investor returns. Inflation is especially worrisome for bond investors who are collecting fixed coupon payments. So I’m glad that we’re getting the expert insights from both of you who run our fixed-income portfolios.
Today we’ll discuss what inflation is, why investors worry about it and whether we think today’s scary headlines are cause for concern or something that we should just not worry about. So, let’s jump right in. Chris, we’ll start right with the basics. What is inflation and why should investors worry about it?
Well, thank you, Charlie. So at its most simplest level, inflation is an increase in the prices of goods and services where we end up paying more for the things that we buy. Or I suppose another way to look at it is to say that it’s a decrease in the value of money that you may have in the bank because that money purchases less than it used to.
Now on the prices front, I think one of the first things that comes to my mind is gasoline. And I think it’s something that many of us can easily relate to. In my own case, last weekend I paid $2.99 a gallon. Well, at the beginning of the year I only paid $2.25. So that’s a quick and recognizable inflation that most of us again can relate to, but there’s more to it than our own personal energy costs. And I say that because the higher costs of gas can easily work its way throughout the economy.
Yeah, that’s right. So everything from airlines and delivery services companies down to companies that have large fleets of cars and trucks, even Uber drivers, they’re all now experiencing higher costs to run part of their businesses. Naturally, they’d like to pass some of that added cost along to consumers and their end users. So that’s why we as consumers should all be aware of it.
I was reading something the other day about something called “shrinkflation” and it’s more of a hidden cost. It’s a bit sneaky. So it’s basically a “cost to consumers” in that they’re keeping prices the same, but they’re reducing the amount of product in a package. So say you as a consumer usually pay $1.99 for a roll of paper towels. Now you’re still paying that $1.99, but before you might’ve been getting 70 sheets per roll and now you’re getting say 50.
Sneaky indeed, Jen. I think that as equity investors or at least the theory goes that as company revenues increase and their earnings should increase as well at a similar pace as out of inflation. So this means that their share price may benefit and rise too. So that’s actually a good outcome for equity investors. However, bond investors on the other hand have a different take. For them and when I say them, I really mean us as well. Our stable income-producing bonds typically have fixed levels of income and they may not keep pace with the general rise in higher prices or said another way, our purchasing power is diminished. And that’s why we say inflation is the enemy or the archenemy of bond investors.
Now in response to inflation, bond prices typically fall, but there could be a silver lining in here, at least for some investors. We’ve been told time and again that when rates rise, prices fall. And that’s perfectly true. But if you’re a bond investor, then you take the income that you’re receiving. If you reinvest some of that back into the market, back into the bond market, then you’re effectively buying new bonds with higher yields.
Okay. So there is a bit of a silver lining for bond investors and for investors in general. But as I mentioned at the top, some inflation is good. When you’re getting a slow, steady increase in prices that’s the ideal environment. But most investors when they hear inflation is rising, they fear a 1970s-style inflation, which, right now, is nowhere in sight.
Right. Yeah. I think what is scaring investors the most is that the most recent reading on consumer prices shows that they’ve risen 5% over the past year, which is the highest since 2008. But first I’d like to say that rising prices aren’t always a bad thing, because it does mean that there is an expansion, which is better than a contraction. It also means that there’s consumer demands that helps drive economic growth. The Fed is targeting 2% inflation, so rising prices shouldn’t be a concern, but you really have to go back to the late ‘80s or early ‘90s. So give or take about 30 years for a time where inflation was consistently above 4%.
And since that time, inflation has averaged a little bit more than 2%, which as I just mentioned is the Fed’s current target. That’s a far cry from the ‘70s-style inflation, which was averaging nearly 8%. Even so over the last year, inflation has averaged just over 2%. I don’t think we’ll be seeing double-digit inflation anytime soon.
I agree. And that’s a good point that over the last year inflation has averaged just 2%. And it’s really the most recent inflation readings that have been high. And everyone, us included have been pointing to something called the base effect as for the reason why we’re seeing this high inflation.
And so that’s some industry jargon, so I don’t want to just leave that there. So Chris, why don’t we simplify that for our listeners and talk about what the base effect is.
All right. Well briefly, the base effect is the impact of data from the same month of the previous year on changes of the same month this year. So today’s year-over-year inflation data looks a little higher because the year ago numbers were abnormally low. Charlie, consider this. In May of 2020 last year, monthly data for the Consumer Price Index and that’s what we’re talking about here, inflation or that’s what measures inflation. A year ago, it registered just 0.1% for the month. While that number has rolled off the radar screen and it’s now been replaced with data depicting a more normal pattern and surprise, it’s higher.
In May 2021, we saw a read in a price increase of 0.6%. So that’s where we’re getting the inflation from. Now this was bound to happen. And when you measure today’s reopening activity against economic activity a year ago, that explains much of why we’re seeing what we’re seeing. Now that the economy is reopening, the biggest increases are in areas most impacted by COVID. So that would include hotels, airfare costs, rental cars, and more. And yes, gasoline would be included in there.
Now for the Fed, the word that they’re using to describe the rise and inflation is transitory, which is really just another way of saying temporary.
Oh good. I’m glad you used that word transitory because that’s another term that’s being used frequently. And the base effect, as you just explained, are comparisons to last year and those are transitory or temporary in nature. But Jen, we’re also seeing some other one-time events that are temporarily having an impact on inflation.
There is no shortage to choose from there. In addition to the base effect, you have the reopening effect. At the onset of the pandemic, companies pulled back on orders because demand had dropped off. So this had helped them to save money as they ran with this tighter inventory. But now that we’re on the flip side with the reopening, everyone is making summer plans that they had to forgo last year or maybe they’re buying a new or used car to once again have to commute to work. But companies that had pulled back on orders are now scrambling to restock their shelves. In some cases, they’re doubling or even tripling their orders.
Then there were some exogenous events that have also recently had an impact on inflation. Think the pipeline ransomware attack, which caused gas shortages along the East Coast right before Memorial Day weekend. The Texas freeze in February took crude oil production offline for a couple of weeks, then you had the ship stuck in the Suez Canal, which impacted global shipping. It’s actually one of the world’s most-used shipping lands. That was huge. Then you have semiconductor shortages, which impact multiple industries from consumer electronics to automotive to industrial equipment.
So certainly a lot that’s been temporary in nature and causing the most spike that we’ve seen. So I think one of the points that we’ve been making as a research team and as a firm and we’ve been emphasizing this is that for inflation to really take hold, we’re going to need to see improvements in employment and in wage growth.
And so our view is that wage inflation is going to lead to more lasting inflation. And while wage inflation has been higher, again, Chris, some of this is transitory so much of it has to do with the stimulus checks from the government.
That’s an excellent point. So spending is up, but incomes, excluding government stimulus payments, are flat. So there’s this belief and Charlie, I include myself into a group that believes this, but once the stimulus effects wear off, so too will spending or at least it will to a degree. And that’s why we believe that today’s elevated inflationary pressures are temporary.
Some of this was recently on display in the most recent retail sales data that we had seen. Retail sales, by the way, were a miss versus forecast, but they do remain strong (or at least they do for now). And we believe that without sustained wage increases to make up for expiring government stimulus measures, the inflation boom that we’re experiencing right now may have trouble sticking around. Again, we’re back to the transitory word.
Exactly. I think we’re all in agreement that there are higher levels of inflation right now, but it’s not really something that’s going to be sustainable, at least in our view right now. And I want to transition a little bit to what this means for investors. I’m glad that you two are here because you’re both our resident experts in the bond space. What are your thoughts on the bond market right now and what our bond investors signaling with regards to inflation?
Well, I’ll begin by saying that the yield in a 10-year Treasury bond, it’s hovering around 1.5%, a little below, a little above but in that general area. Now this is after peaking at nearly 1.8%, not that long ago. So it’s clear that the bond market and bond investors are neither preparing for nor panicked about inflation. In fact, I think we could argue that the opposite is happening because rates have generally fallen over the past several weeks and that’s just not consistent with long-lasting meaningful inflation.
And also breakeven inflation levels, which they show what inflation is predicted to be have been falling since mid-May. And to me this indicates that more investors are thinking through the year-over-year comparisons and they’re thinking about what comes next. So if inflation was a concern, yields would be heading higher, not lower.
Well, That’s good. And the old adage goes that the bond market gets it right. So that’s a good sign for investors considering inflation. I think the other asset class in addition to bonds that gets mentioned a lot with inflation is commodities. And we’ve seen some very big swings in a number of commodity prices so far this year.
We are indeed, Charlie. And I was talking with a builder just a week or two ago who was lamenting the erratic but higher prices that he’s paying for lumber to build the houses that he constructs. So the price of lumber, which has been on a tear (or at least it had been earlier this year), has seen its price drop by almost half over the past five or six weeks. Why is this happening? Because shortages, supply chains and markets just genuinely correct over time. And these things usually get sorted out.
There are some other areas that are likely to remain elevated. I’d say those connected to travel, leisure, entertainment, just to name a few. But as consumers return to moving about, I expect gas prices to remain high as well as sales at hotels, restaurants, bars. This means there’ll be an awful lot of uneven business activity and yes, some areas of inflation in the months ahead. But once this pent-up demand is let loose, I think things will even out over time.
Right. I think the other adage related to inflation is that the cure for high prices is high prices. And those high prices that are in the market today, whether it’s lumber or hotels or gas, will deter people from spending on some of those categories. And so that may lead to lower demand, which will temper the price increases.
All right, before we wrap up this podcast, I do want to ask you about the Federal Reserve. Again, you’re, you’re both running our bond team. And so it’d be interesting to hear what your thoughts are on the recent actions in recent commentary from the Fed.
Well, for starters, Charlie, I want to just say that I give Jay Powell credit for sticking to his guns on the transitory theme when so many market observers and economists were really calling him out for it, suggesting that as leader of our country’s central bank, the Federal Reserve, he was making a policy mistake by not addressing inflation more forcefully or taking actions. So I give him credit for that.
Today, we’re seeing more and more economists joining his camp, which is the transitory as opposed to runaway inflation. Now regarding recent discussions of tapering or the reduction of bond purchases, I believe that he should. And I believe that we should be discussing this and planning for this. We as the economy, we’re no longer in this crisis mode. So let’s get things back to normal all around. And if the Fed does taper or when the Fed does taper, remember that’s actually a good thing. It means the economy no longer needs a helping hand.
Yeah. I agree with everything Chris just said. The Fed is not on autopilot and nobody should want or expect them to be. They’ll continue to react as the data comes out; when the economy changes so should Fed policy.
All right. Thanks, Jen. I think that’s a great point to wrap up with. So thank you both for joining me today. The big takeaways that I have from our conversation is that inflation headlines they’re everywhere right now, but we expect them to be short-term in nature. And because wage inflation is doesn’t look like it’s going to be sustainable. We don’t think we’re at the point where inflation will be sustainable as well. And as you both expertly pointed out, this is being confirmed by the bond market, which is telling us that high inflation won’t last. As always, we’ll continue to monitor these developments and see how this plays out.
So this has been Charlie Toole, Chris Keith and Jen Yousif from Adviser Investments thanking you for listening to The Adviser You Can Talk To Podcast. If you’ve enjoyed this conversation, please subscribe and review our show. And you can check us out at adviserinvestments.com/podcast.
Your feedback is always welcome. If you have any questions or topics that you’d like us to explore, please email us at firstname.lastname@example.org. Before closing, I’d like to thank Ashlyn Melvin. She does all the hard work to get us set up with this podcast. She had to do a little bit of extra work today. Thank you, Ashlyn, for the help and thank you all for listening.
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