Some of these effects are already apparent. For the first time in almost a year, headline inflation (CPI) and core inflation (which excludes volatile components such as energy prices) printed above the Fed’s 2.0% target in March. Higher inflation could well propel the push for higher speed policy normalisation. According to the March FOMC Minutes, Fed officials have grown more confident in the inflation outlook, barring the realisation of downside risks to their projections. Strong inflation reports in March and April should keep the Fed on track for a 25 basis points rate hike in June – and enable it to deliver four in total this year. However, we do not believe that the inflation rate will ramp up too dramatically in the period ahead. Technological developments in areas such as healthcare or communications, unconventional petroleum production and greater investment in productive capacities are factors that could counter at least some of the inflationary pressures.
US headline and core inflation both ahead of the Fed’s 2% target in March
Source: Lyxor International AM, Reuters Eikon Analytics. Data as at 31 march 2018
Despite the relatively benign nature of the above, investors are concerned by other issues. Asset allocation has become more complex given greater political risk (like the possible trade war between the US and China, less support from central banks and the high valuations most traditional asset classes are displaying. As a result, we expect to see a volatility regime shift, with markets much more volatile than they have been in recent years. Some of the market moves we’ve seen in February and March were, in our view, the precursors for this period of instability.
The positive correlation between the returns of fixed income and equity assets also impedes efforts to diversify portfolios more effectively. Historically, an investor who adopts a more cautious position tends to reduce their exposure to equities and increase their weighting to fixed income. That may not however be wise in a rising inflation environment where greater caution is required on conventional bonds.
Inflation-linked bonds may be better suited to this new normal.
Right place, right time
Our research shows assets related to inflation tend to perform well in the more advanced stages of the economic cycle. The expansion in the US is undoubtedly entering old age – so the probability of a recession in the next two years is increasing.
Holding commodities, most notably petroleum products, tends to prove beneficial in advanced stages of the cycle (especially 12 months before a recession), both in terms of absolute and risk-adjusted returns. The analysis takes into account economic cycles in the US, as measured by the NBER, since 1970. Inflation breakevens have been fairly supported by the recent move in energy/ oil prices (Brent above $72/bbl on 17 April). Net flows into short-dated TIPS ETFs have been fairly robust over the past month (despite net outflows in March in all-maturities ETFs).
Our key calls
For now then, we are looking to overweight assets such as TIPS and inflation breakevens, as well as commodities and those equity sectors that are most sensitive to inflation expectations.
Whether you choose TIPS or breakevens depends on your view on where inflation goes next. TIPS are the conventional choice, but breakevens may be a better play if you believe people are underestimating just how high inflation could climb.
Energy stocks: a good proxy to US inflation breakevens
Source: Lyxor International AM, MSCI, Bloomberg. Data as at 31 march 2018
Why Lyxor for inflation
Lyxor has the most far reaching and complete range of inflation-linked ETFs in Europe, with exposures covering the US, Europe and the UK. Our Core US TIPS ETF is the cheapest on the market at just 0.09%. If you’re looking to not only protect yourself against rising inflation but also rising rates, our unique inflation expectations ETFs are designed to tackle both. With over 12 years’ experience managing inflation-related ETFs, and €3.3bn in AuM, look no further for dependable solutions to rising inflation.
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