After years simmering on the back burner, inflation risk is becoming a more immediate concern for many investors. Late-cycle U.S. fiscal stimulus, escalating trade tensions and a narrowing output gap are just some of the factors bringing inflation risk to the fore, and we believe many investment portfolios may not be sufficiently prepared. Inflation-linked bonds (ILBs) provide an explicit link between returns and inflation while also offering a key source of diversification from traditional stocks and bonds. Jeremie Banet, real return portfolio manager, and Berdibek Ahmedov, fixed income strategist, discuss PIMCO’s views on inflation pressures and how inflation-linked bonds may play an important defensive and diversifying role in investors’ portfolios today.
Q: Do you see inflation pressures building over the cyclical and longer-term horizons in the U.S. and other major economies?
A: Yes. At PIMCO, we use two approaches for forecasting inflation: a bottom-up model for near-term (cyclical) inflation, and a top-down approach to gauge longer-term trends.
Our bottom-up approach breaks down inflation expectations for each subcomponent of the consumer price index (CPI) basket, an approach that has been useful historically at forecasting inflation within a 12-month horizon. Based on these models, we see U.S. core CPI reaching 2.2% by the end of 2018 (and view a range of 2%–2.5% as reasonable). Part of the acceleration would result from the large drop in wireless services prices in early 2017 rolling off the one-year measure of seasonally adjusted core CPI.
Other factors support the underlying inflation trend. Goods prices have experienced actual deflation for most of the past five years, with prices dropping by as much as 1% year-over-year. Going forward, we expect core good prices to be flat, thanks to increased cost pressures globally – think higher commodity prices and higher inflation in China (and also globally), with a weaker U.S. dollar fanning the flames. In the U.S., shelter inflation is the largest CPI component, at 32.7%. This category is driven by rent inflation, which we expect to move sideways from here after a year of modest average disinflation. While higher rates tend to make renting more attractive than buying, the supply of rental units remains high in major cities such as San Francisco and New York. Finally, gradually rising wages should be supportive of services (ex shelter), particularly those that are labor-intensive.
All in all, our base case is for U.S. inflation to firm and rise toward the Federal Reserve’s target over the cyclical horizon. Our global forecast for 2018 has headline CPI inflation in 2.0%–2.5% range, representing a modest increase from 2017, largely due to accelerating price rises in China, Japan and India as well as the U.S.
Turning to our longer-term top-down analysis, we look at the output gap, inflation trends and expectations, and lagged changes in currencies, commodities and import inflation to model our expectations going further out. And these models recently started to signal meaningful risks of a global inflation regime shift. The U.S. unemployment rate has fallen below the so-called nonaccelerating inflation rate of unemployment, or NAIRU. Global disinflation is taking a breather, partly because of higher commodity prices and a weaker U.S. dollar. What’s more, the Trump administration’s fiscal reform package resulted in a $1 trillion fiscal boost at a late stage of the economic cycle. A fiscal stimulus of that size in an economy functioning near capacity is extraordinary, and we estimate that it could influence inflation more than growth, which is constrained by limited spare labor supply. Therefore, the Phillips curve effect may finally kick in and have a positive impact on wages. The possible impact of White House policies on inflation ranges from “good” inflation (from fiscal-led higher wages) to “bad” inflation (from restrictive immigration policies or if recent tariffs escalate into a trade war).
Q: Given the outlook above, do you think ILBs should be included in strategic asset allocations? What do you view as the optimal allocation to ILBs?
A: We believe ILBs should be part of a strategic asset allocation toolkit in investor portfolios. Whether the starting point is a simple 60/40 mix of equities and bonds or something more complex and diversified, nominal duration and equity risk premia are going to be the main return drivers and risk factors for most portfolios that are constructed with one macroeconomic risk factor in mind: growth. Broadly speaking, when growth is higher, equities have tended to do well, and when growth is lower or negative, bonds have tended to do well. This growth-minded portfolio seems well-diversified, and the approach has worked well over the past 40 or so years, a period when inflation has generally been stable or trending lower. The long-term disinflation trend has been a major tailwind for investors.
However, this approach likely won’t work as well in a higher-inflation environment. Nominal duration and U.S. equity risk premia have a clear negative sensitivity to inflation: If inflation moves higher, investors with typical “balanced” portfolios will likely see that negative correlation do damage to their portfolios. To diversify against such inflation risk, we believe investor portfolios should include assets that have a positive correlation to inflation, such as ILBs. We view an ILB weighting of 10%–15% of the total portfolio as a neutral starting point for most investors, with deviations from that range depending on the investor’s view of inflation risks and market valuations of those risks.
Q: What is your view on current ILB valuations, and is now still a good time to buy?
A: ILB valuations are informed by two important metrics: breakeven inflation (BEI) levels, which measure how much inflation is priced in by market participants, and real rates.
Let’s start with BEI (see Figure 1). We see most of the value in the U.S.: Currently priced for inflation levels near 2%, TIPS (Treasury Inflation-Protected Securities) are attractively valued relative to where we expect U.S. CPI to be realized, as mentioned above.
Investors should remember that the Fed target is for 2% personal consumption expenditure (PCE) inflation, which is equivalent to 2.4% CPI after adjusting for differences between the two indexes. The market currently is pricing for the Fed to undershoot its target for the next 30 years.
In our opinion, part of the reason the BEI for TIPS is below the Fed’s inflation target is that despite the recent recovery, the inflation risk premium is still negative (see Figure 2). Put another way, the TIPS market is implying that investors are still more worried about disinflation than rising inflation. The shape of the BEI curve indicates that the market is pricing some acceleration in inflation, but it peaks at 2.2% in 2023, only to drop back to 2% on average between 2023–2028. We view this inversion of the BEI as evidence that the inflation risk premium is negative. Even for nominal Treasuries, most models point to a low or even negative term premium. If investors were really concerned about inflation risks, why would they buy 30-year nominal Treasuries at a 3% yield?
The market today offers investors an attractively priced opportunity to incorporate or increase inflation hedging in their portfolios. We think at current valuations, ILBs offer a relatively “cheap” defense against higher inflation.
Let’s turn now to the second metric, real rates. At current levels, we do not see much risk of real interest rates rising sharply. Similar to our views on BEI, we view long-term real interest rates in the U.S. at 1% as being attractive both in an absolute and relative sense. Relative to the U.K. and France, U.S. real rates are higher by 2.5% and 1.4%, respectively.
Q: PIMCO offers two ILB products: one with a low duration and one with a higher duration. How should investors think about these two options, and is one more suitable for the current environment?
A: PIMCO’s ILB offerings (see Figure 3) differ in terms of their duration profiles and the country composition of their benchmarks.
Our GIS (Global Investors Series) Global Low Duration Real Return Fund, which is focused on global ILBs and includes a greater allocation to U.S. TIPS than its benchmark (which is approximately 60% TIPS), may be better suited for investors who seek inflation protection with a low duration. This fund tends to have a higher correlation to realized CPI and commodity prices than the full duration counterpart. It also offers a higher potential hedge against more extreme inflation surprises, such as those that could arise from U.S. trade policies, which would likely be transitory in nature.
The GIS Global Real Return Fund, our full duration offering, may be used as a duration anchor in a portfolio rather than to diversify from other risk assets. When compared with the low duration strategy, the benchmark has more duration coming from the U.K. than the U.S.
We see potential to combine the two products to achieve a desired duration target. For instance, opting for a one-third allocation to the full duration offering and two-thirds to the low duration option provides roughly six years of duration, on average. And given flat global yield curves, the yield differential between the two products is narrower than it has been for years.