A new playbook for higher inflation

One important consequence of the joint monetary and fiscal policy revolution for strategic investment decisions is the potential for a more muted response of nominal yields to higher inflation – a break from the past patterns. See our paper Preparing for a higher inflation regime of September 2020 for why we see higher medium-term inflation. We expect the disinflationary forces from the Covid-19 shock to dissipate and give way to structural inflationary forces, such as rising production costs globally and the impact of changing central bank policy frameworks. Central banks appear committed to limit any rises in nominal yields even as inflation picks up. Investors will need a new playbook to navigate this. Yet market pricing of inflation, based on breakeven inflation rates, suggest expectations of low inflation persisting are still widely held. The large gap between our expectation of inflation’s likely trajectory and that priced in by markets offers a strategic investment opportunity, in our view. We underweight government bonds and maintain a higher strategic allocation to equities than in typical periods of rising inflation.

One important consequence of the joint monetary and fiscal policy revolution for strategic investment decisions is the potential for a more muted response of nominal yields to higher inflation – a break from the past patterns. See our paper Preparing for a higher inflation regime of September 2020. We expect the disinflationary forces from the Covid-19 shock to dissipate and give way to structural inflationary forces, such as rising production costs globally and the impact of changing central bank policy frameworks. Yet market pricing of inflation, based on breakeven inflation rates, suggests that expectations of persistently low inflation are still widely held. We see medium-term U.S. inflation averaging 2.8% over the five-year period starting 2025 – well above current five-year U.S. breakevens. See the chart below.

A higher inflation regime

U.S. 10-yield and breakeven rate vs. BII estimate

We believe this year’s macro policy revolution could fundamentally change the relationship between interest rates and inflation. Why? First, central banks are reviewing policy frameworks with the objective to lift inflation expectations. The Federal Reserve explicitly said in August it will embark on a flexible average-inflation targeting regime and that a tight labor market will no longer be a factor in determining the policy stance. The European Central Bank is poised to announce changes to its framework next year. This shows more willingness from central banks to let inflation run above target to make up for past shortfalls, suggesting policy rates will be less responsive to rising inflation than in the past. Second, the blurring of lines between monetary and fiscal policy during the Covid-19 policy response has set a precedent for supporting fiscal objectives. We believe central banks will likely be quicker to step in to suppress yield rises and prevent any tightening of financial conditions, including employing yield curve control policies to contain longer maturity yields.

The bottom line: We expect the knock-on impact of rising inflation on nominal bonds yields to be lower than in the past and see the response to higher inflation expectations to be reflected primarily via lower real yields. This decoupling of higher nominal interest rates and inflation means price pressures can be supportive of expected equity returns – and the case for a rotation from growth sectors to value is weaker.

The inflationary environment that we see playing out breaks from historical patterns, but there are some historic parallels. We find parallels between the Federal Reserve’s stance on inflation today and the mid to late 1960s. Prioritizing full employment became the political consensus on a view that inflation would stay low even in a tight labor market. But as this policy stance became clear when the Fed prioritized full employment over fighting inflation, inflation expectations started to drift meaningfully higher. One lesson from the 1960s: inflation risks are highest when conviction in inflation staying low is at its strongest and that view is entrenched in intellectual and policy frameworks. A more tolerant inflation stance weakened the link between interest rates and inflation expectations. See the chart below. We expect this to occur again - but to a greater extent – due to the macro policy revolution. Another historic parallel is Japan’s experience after the introduction of Abenomics. Japan launched large-scale monetary easing aimed at suppressing longer-dated yields, with a goal of raising inflation expectations – and ultimately inflation – after decades of deflation or persistent inflation shortfalls. The result: breakeven inflation expectations rose yet nominal yields did not, meaning real yields slid lower. The rise in inflation expectations was temporary, yet Japanese real yields stayed lower and their historic relationship with inflation expectations and with U.S. real yields weakened. See the chart below. The key difference versus the policy revolution today is that monetary easing in Japan was not accompanied by such forceful fiscal stimulus – and even fiscal consolidation with the sales tax increases. We expect inflationary dynamics in the coming decade to be more persistent than observed in Japan. The lesson? Policy measures can decouple rates and inflation expectations, thereby altering cross-asset correlations.

The Japan experience

Correlation of real yields. Japan vs. U.S., 2003-2020

We expect the sensitivity of nominal yields to inflation expectations – or the pass through – to erode in developed market government bond markets, particularly in the U.S. where we see greatest upside to inflation expectations. To establish the extent to which this may happen we studied the historical sensitivity of U.S. nominal government bond yields to inflation expectations from 1962 – the earliest available data – to the present day. We considered both market pricing and survey-based measures of inflation expectations and zeroed in on periods of rising inflation. The pass through from a rise in inflation expectations to nominal bond yields is shown on the chart below. On average, for a 100 basis point rise in the five-year breakeven inflation rates, the five-year nominal yield has risen 75 basis points. The sensitivity of the 10-year nominal yield is lower at about 50 basis points. Longer maturity bonds are less responsive to inflation expectations as other drivers such as the term premium matter more. This tells us that, even if we were to look purely at history, we shouldn’t expect a full pass-through from rising inflation expectations to nominal yields. But, importantly, in a period more like the one we anticipate – a new inflation playbook with parallels to the U.S. in the late 1960s and Japan following Abenomics – we expect lower sensitivity of yields to inflation than averages for the overall period would suggest. See the green bars on the chart below. For our CMAs, we assume the revision higher in our inflation expectations has no pass through to our yield estimates (orange dot in chart below).

Lessons from history

Nominal yield sensitivity to breakeven shocks, 1962-2020

The market implications of the new inflation playbook are significant. Less responsive nominal yields means a narrower expected range for yields, diminishing the downside for government bond returns typically associated with higher inflation. Yet their smaller negative correlations with risk assets still present a challenge to their role as portfolio ballast, in our view. Inflation-linked bonds could see real yields falling as higher inflation is priced in, increasing their expected returns relative to nominal government bonds. In our CMAs, expected five-year U.S. equity returns are around 1% higher than they would have been had we assumed the historic inflation playbook where nominal yields rise. Historically, from 1970s to now, the falling real rate environment has been supportive of equity returns, as seen in the yellow bars on the chart below. During the same period, a rising nominal rate environment coincided with lower equity returns, as seen in the orange bars. This is a simple illustration of why taking a view on nominal and real yields is an important consideration for equity allocations.

Real vs. nominal

Monthly U.S. equity returns vs. bond yields, 1973-2020

Another key variable is the growth outlook. We expect inflation to rise without growth expectations materially shifting. If growth expectations were also rising, this would likely be a further boost to equity expected returns. There are sectoral impacts too. The changing relationship between interest rates and inflation suggests the implications for traditional growth and value sectors may not be as clear. The outperformance of long duration and interest rate sensitive sectors such as tech, typically considered pro-growth sectors, and the underperformance of traditional value sectors, such as energy and financials, could persist if the low rate environment does. In the chart below, we show the sensitivity of equity sectors to a 50 basis point rise in nominal interest rates. Typically, higher valued growth sectors with lower equity risk premia have higher sensitivity to interest rates. All else equal, we believe these sectors can weather this rising inflation regime better than the past because rates will be less of a drag. Shifting cross-asset correlations are another possible consequence. Range-bound nominal yields - floored by an effective lower bound and capped by monetary easing – means nominal bonds would be less correlated with other asset classes than they typically have been. See our paper Bonds and ballast: testing the limits for more on the challenges to fixed income allocations brought about by bond yields getting closer to their effective lower bounds. The policy revolution brought about by Covid-19 exacerbates these trends.

Low rates a boon for rate sensitive sectors

U.S. equity sector CMA sensitivity to rates, November 2020

Our outlook is not one of inflation running very high above policy targets. Yet even the modest rise we anticipate is a significant departure from the experience of recent decades of inflation persistently undershooting central bank targets. A new inflation regime has major implications for strategic asset allocation decisions, in our view, with a material cost to both getting the inflation call wrong and misinterpreting the impact of inflation on nominal and real yields.

We showed earlier the historical impact of ignoring inflation. The charts below illustrate the potential impact of making flawed assumptions about its impact on asset prices. We show in the charts how our CMAs and hypothetical 10- year U.S. dollar unconstrained SAA would differ in two scenarios. In the first scenario – the historical playbook – higher inflation expectations feed into higher nominal yields. In the second – the current playbook embedded in our CMAs – higher inflation expectations feed through less to nominal yields and more to lower real yields than the past. The two scenarios have markedly different expected outcomes. Following our current playbook, we see lower real yields and range-bound nominal yields resulting in higher expected returns for both government bonds and equities versus the historic playbook. In particular, we see less interest-rate sensitive equity markets or sectors doing better than they would typically in a rising inflation, rising nominal yields regime.

Portfolio implications of the current vs. historical inflation playbook

Hypothetical strategic 10-year U.S. dollar allocation under different inflation scenarios, November 2020

The portfolio implications: Investors should consider positioning portfolios for higher inflation, yet not as they might have done in the past, in our view. In our base case, we prefer holding more inflation-linked bonds and more equities at the expense of holding fewer nominal government bonds. The case for a larger allocation to inflation-linked bonds we originally laid out in our paper Readying for real resilience of August 2020 is stronger, in our view. Current breakeven inflation rates suggest markets are not yet pricing in a higher inflation regime, opening a window of opportunity for long-term investors, in our view. The geographical distribution of the inflation-linked bond market is narrower than nominal bonds and could be a limitation. Potential caps on nominal bond yields mean our preferred equity allocation stays higher than it would typically in an inflationary environment. We calculated the average annual 10-year expected return of these hypothetical portfolios using our latest CMAs to show the implications of positioning for inflation but using the historical playbook. We estimate a drag of between 35-50 basis points annually over the next 10 years based on our range of expected returns across asset classes. This estimate is illustrative only and does not take into account other factors such as the precise impact of inflation on individual equity sectors. The estimated drag on returns at the top end of the range is equivalent to our assumptions of the alpha contribution to an SAA of a top-quartile U.S. fixed income manager as shown in our 2018 paper Blending alpha-seeking, factor and indexing strategies: a new framework.

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