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Portfolios May Benefit From Inflation‑Linked Bonds as Price Pressures Mount

The market today offers investors an attractively priced opportunity to incorporate or increase inflation-hedging strategies.

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: How can investors prepare their portfolios for higher inflation?

A: We believe inflation-hedging portfolios should consider incorporating an ILB foundation. For U.S. investors, TIPS should likely represent that starting point, given their contractual link to U.S. CPI. TIPS tend to perform best in a low growth, high inflation environment and worst in a deflationary productivity boom.

Given a number of inefficiencies present in the TIPS market, active management can play an important role in enhancing return potential. PIMCO’s Real Return Strategy uses a full complement of both top-down and bottom-up active views to add value beyond what can be achieved passively. We see this strategy as a beneficial core of fixed income portfolio construction as it tends to diversify duration risk while hedging against an increase in inflation.

TIPS can also be used in combination with other inflation-hedging asset classes such as commodities or real estate investment trusts (REITs).  For example, TIPS can be used side-by-side with a commodity investment or as collateral backing the commodities exposure. PIMCO’s CommodityRealReturn Strategy offers investors a two-in-one allocation to both TIPS and commodities. 

TIPS can also be used as the starting point to construct multi-real-asset portfolios such as PIMCO’s Inflation Response Multi-Asset Strategy, which incorporates TIPS, commodities, REITs, currencies and gold in combination, with each strategic allocation to these assets designed to contribute an equal amount of risk to the overall portfolio (i.e., risk parity). 

For more of PIMCO’s views on the complex drivers of global inflation, please visit our inflation page

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The Author

Berdibek Ahmedov

Product Strategist, Global and Real Return

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Disclosures

The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. 

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2018, PIMCO.

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