Rising Phoenix

John Leiper – Chief Investment Officer – 17th August

In The Return Of Inflation (5th June 2020) we made the case for a transition from the existing deflationary narrative to one in which markets start to price-in inflation.

Earlier in the week this theme rose to the forefront of investors’ minds as both headline and core US inflation (which excludes volatile food and energy prices and is seen as a more reliable gauge of price trends) rose 0.6% in July, representing the largest monthly gain in three decades. On an annual basis, core inflation rose 1.6% to a four-month high versus a forecast of 1.1%. Producer price inflation also rose in July, up 0.6% month-on-month, whilst core PPI rose 0.5% versus expectations of 0.1%.  

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As a result, inflation expectations, measured by the 10-year breakeven rate, continued to rise, reaching 1.68%, up from 0.60% just a few months ago.

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We have benefited from the rise in inflation expectations via our position in TIPS (Treasury Inflation-Protected Securities) and earlier this week we further increased our allocation to this position.  

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The rise in inflation expectations has not helped demand for long-dated Treasuries as evidenced by this week’s 30-year bond auction. The yield of 1.406% was a full 2bps above market expectations and the bid to cover ratio of 2.14 was the lowest level since July 2019. The weak auction was a signal from the market that it is struggling to fund the huge surge in Treasury supply to pay for the coronavirus rescue package, especially at the long end of the curve. This is consistent with the recent steepening of the yield curve as demonstrated by the difference between the 2- and 30-year US Treasury yield. We retain our relative preference for shorter dated Treasuries as detailed in Don’t Fight The Fed (26th May 2020).

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The recent rise in long-dated Treasury yields also led to a spike in real yields, calculated by subtracting inflation expectations from nominal interest rates. This contributed to this week’s sell-off in precious metal commodity prices although given the strength of the prior rally a pull-back was always on the cards (indeed, we mentioned the possibility in our prior blog, All That Glitters (31st July 2020)).

 

On mobile: review detail in landscape mode

To summarise, I have been concerned about a potential pick-up in inflation for some time and this week’s CPI and PPI numbers may represent the early stages of this theme.

Indeed, these official numbers likely understate actual inflation, given how they are calculated. The coronavirus has caused significant upheaval to all our lives. It has affected the way we work and the way we live. For example, we now spend far less on travel, transport and restaurants and more at home, on food (baking and experimenting) and hobbies (I for one am now completely and inexplicably obsessed with cycling). Because the basket of goods and services used to measure inflation is relatively static, typically updated once a year, these indices do not reflect the dramatic changes in spending patterns that are taking place at this very moment. To provide another example, in the calculation of inflation the US Bureau of Labour Statistics allocates an 8% weight to spending on groceries and 15% to transportation but in a recent study conducted by the Harvard Business School, current spending on groceries is closer to 11% and on transport it is just 6%. That’s bad news given food prices have jumped 4.6% in the US. In China, it’s even higher at 13.2% (although much of that is due to the record flooding which has decimated thousands of hectares of crops).

Then there is the issue of the Fed’s approach to inflation which is expected to change following a year-long review. The official announcement is expected in September and will likely see a shift in policy towards average inflation targeting i.e. letting inflation run hot over the 2% target to ensure it averages at that level over a specified time frame.   

As such we continue to like inflation-linked bonds, shares of companies with real purchasing power, commodities and other real assets.

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.  

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