Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Inflation is threatening your investments, and savings too!
Althea Spinozzi
Head of Fixed Income Strategy
Summary: The market is desperately denying that inflation is rising, even when people are paying more for necessary goods amid the pandemic. Before it's too late, it is crucial to identify instruments that can hedge investment and savings against inflation. Compared to gold, we favour Treasury Inflation-Protected Securities (TIPS) as they provide a stable cash flow which can be reinvested in new arising opportunities. They are also an excellent diversification tool as they do not correlate with fixed income and equity products.
In life and the financial market, it is true that by not deciding to move in any direction, you are actually making a choice. This is especially true today as optimism fuels an overleveraged stock market; but, deep down, everybody knows that there are incredibly significant economic problems. Investors buying into overpriced stocks and pushing prices even higher insist on seeing a glass very much full. They desperately try to ignore that a drop of too much water will have the glass spilling all over.
This is very much what is happening with inflation. There are clear elements today that are telling us that inflation will eventually rise. However, because the human brain has removed from its memory periods of high inflationary pressures, investors still flock the equity market and risky credits. People believe that central banks worldwide will be in their perpetual rescue. Well, the market today is a clear example of central banks failures. Desperate monetary policies have not been able to ignite inflation and prevent financial crises. Therefore, central banks will also most likely be powerless to save investors from overshooting inflation.
Inflation is rising, and the market knowingly ignores it.
It is crucial to understand that we are already living in an inflationary environment; however, the CPI index is failing to reflect changes in prices. The CPI index is a quite controversial measure for inflation because it compares the price of a fixed basket of goods and services spanning two different periods. This basket is decided by somebody that states we need certain goods and services over others to maintain a constant standard of living. The reality is that this basket can be different for any one of us because we give value to objects and services differently.
The Covid-19 pandemic has set in motion a sequence of events that are already exacerbating inflation as the stuff we need today is more expensive. I have analyzed data coming from the U.S. Bureau of Labor Statistics and the picture that comes out from them, it's clear. The pandemic has caused a price surge for those items that we actively need, while it provoked a price drop for those items we do not need any longer.
For example, the food at home has become more expensive together with housekeeping supplies and medical care. Travelling, women clothes and public transportation have considerably fallen in price.
Secondly, the Treasury has been issuing increasingly fewer TIPS in the market.
Therefore, while the upside to hold these securities until maturity vanishes as the coupon that they pay is very low, price appreciation potential continues to be massive.
Given the low supply of Treasury Inflation-Protected Securities in the primary market, as soon as inflation expectation rise, we can expect demand to increase fast pushing TIPS further up.
Real assets, commodities and TIPS are investors' best bets in an inflationary environment.
Treasury Inflation-Protected Securities and gold are not the only assets that can give you protection as inflation rises.
During periods of high inflationary pressure, real estate assets rise in value as rents soar and demand to purchase a property increases. Several ETFs track the prices of these assets; however, the table below, we have highlighted the iShare Core US REIT, which gives exposure to the U.S. real estate market.
The stock market will be volatile as inflation rises, and CAPEX will most likely grow faster than revenues. However, growth stocks can have a nice upside in such an environment. Similarly, U.S. Large-caps Stocks will be able to mitigate better a blow coming from inflation compared to mid-cap companies. In an inflationary context, we dislike developed foreign stocks and emerging market stocks.
Within the fixed income market, whatever provides a low yield will fall in value fast, this is why we dislike investment-grade bonds and sovereigns. TIPS and high yield bonds will be the only fixed income securities to be able to provide a cushion against inflation.
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