Strategic Income Opportunities Fund Monthly Insight

What will higher wages mean for
inflation and rates?

Oct 25, 2018

Wage growth is picking up. But the effects
may not be the same as in the past.

The U.S. labor market remains strong and inflation is running near the Federal Reserve’s target rate. At this point, long-term interest rates are likely to react to the shark closest to the boat, i.e., higher wages, which have historically transmitted into higher inflation. (Inflation drives long-term rates higher because bond investors require higher compensation for lending their money when prices are expected to rise.)

However, the fact is that while wages have improved at a decent pace, we have yet to see that translating into excessive price increases at a general level. We believe this is attributable to secular trends. Household savings rates have risen and consequently, consumers are spending a lower percentage of their wages. Additionally, the new economy evolving today is replete with technology-driven disinflation in the goods sector. We think wage gains are unlikely to result in much higher inflation from here, unless corporate pricing power shifts meaningfully higher, and it is even possible that the increasing price of labor instead compresses corporate margins.

We think long-term interest rates will move higher over the coming weeks as a knee-jerk reaction to higher wage growth. However, we anticipate a more subdued reaction from the Fed than many market participants expect. We think the Fed is likely to maintain its path of raising policy rates in 25-basis point increments (+0.25%) in December and only a couple of times in 2019.

Outperformance with lower volatility

Outperformance with lower volatility chart

Source: Morningstar as of 9/30/18. Returns are from 9/30/17 through 9/30/18. Volatility is measured from 9/30/17 through 9/30/18 using daily returns. For standardized performance of the BlackRock Strategic Income Opportunities Fund, click here.

In the Strategic Income Opportunities Fund, we hold the majority of duration in the 0- to 5-year part of the yield curve. We maintain minimal exposure to longer rates as we expect the curve to continue to steepen. We slightly reduced the fund’s inflation protection positions (in breakeven form) on the front end of the curve given our view that inflation may decelerate in the coming months.

We recently made tactical additions to the fund’s investment grade and emerging market allocations. Lower-than-expected supply is providing a strong tailwind for investment grade credit, and the new-issue market is offering higher yields. While we continue to hold high-quality names for income generation, we remain cautious on corporate credit more broadly given rich valuations.

Emerging markets continue to face the headwinds of a stronger dollar, global trade tensions, and local political uncertainties. However, we believe price weakness has created value in the space. We hold select positions in China, Argentina and Indonesia.

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