Muscle Memory
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 euro zone 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 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.
Erik Knutzen, CFA, CAIA and Managing Director, is Co-Head of the Neuberger Berman Quantitative and Multi-Asset Class investment team and Multi-Asset Class Chief Investment Officer. Erik joined in 2014 and is responsible for leading the management of multi-asset portfolios, driving the asset allocation process on a firm-wide level, as well as engaging with clients on strategic partnerships and multi-asset class and quantitative solutions. To learn more, see
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