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Fixed income

Inflation considerations: preparing income portfolios for the next risk

Anders S. Persson
Chief Investment Officer, Head of Nuveen Global Fixed Income
Nathan S. Shetty
Head of Multi-Asset
Brian Griggs
Managing Director, Portfolio Strategist
Inflation considerations

Highlights

As the world emerges from the coronavirus pandemic, a combination of easy monetary policy, massive fiscal stimulus, a rebounding labor market and rising consumer spending has led to increased inflation pressures. How can investors manage the potential risks while also positioning portfolios to take advantage of the shifting environment?

Are inflation fears warranted?

U.S. consumer price inflation has accelerated to more than 6% year-over-year, solidifying 2021 as a sustained period of high inflation that has not been seen since the early 1980s (see figure 1).

Figure 1: Inflation is elevated, but for how long?

What caused this inflation spike?

Historic stimulus programs were implemented by governments around the world throughout 2020 and 2021 to combat the expected economic fallout of COVID-19 and work-from-home policies.

Major central banks quickly cut rates to zero in 2020 and engaged in direct purchases of fixed income securities, known as quantitative easing (QE). QE reduced the supply of high quality fixed income securities on the open market, pushing fixed income investors out on the risk curve. In turn, corporations had access to easier financing to continue their operations despite the economic shutdown. In fact, 2020 saw $1.9 trillion in U.S. investment grade corporate bond issuance, a 64% increase versus the previous 10-year average. In 2021, $1.5 trillion has come to market through the beginning of December.

Economic growth data is the strongest in decades, fueled by vaccine rollouts and unprecedented federal fiscal stimulus. Household net worth has hit new all-time highs thanks to higher savings and rising asset prices (see figure 2). The trillions of dollars in savings amassed during the pandemic have supported robust spending growth.

Figure 2: U.S. consumers are still supported by growing wealth, rising incomes and excess savings

U.S. consumer demand for finished goods remains strong, continuing to overwhelm global supply chains that are still hampered by COVID-19 (see figure 3 for the trend in the U.S.). We expect this dynamic to moderate in 2022 as supply increases and consumer preferences shift to services.

Figure 3: Share of U.S. consumption spent on goods is still abnormally high
Household net worth has hit new all-time highs thanks to higher savings and rising asset prices.

No, we’re not returning to the 1970s

In the early 1970s, the U.S. Federal Reserve misjudged how loose it could run monetary policy at a time of large budget deficits, wage and price controls and the U.S. dollar’s departure from the gold standard.

As a result, prices rose in the U.S. at a time of high unemployment. The so-called Misery Index — the sum of the inflation rate and the unemployment rate — peaked at 22% in 1980, with 14.4% inflation and 7.3% unemployment.

Today’s scenario is much different. For the first time in decades, investors find themselves in a high-pressure economic system. Inflation is running high in developed economies, while unemployment continues to trend lower and wage growth is accelerating. The current Misery Index for the U.S. is 10.4% (6.2% inflation and 4.2% unemployment), slightly above the long-term average of 9% (see figure 4).

Further, the underlying components of the CPI basket showing the largest increases are different today. The Atlanta Fed publishes indexes that distinguish the rate of change of the sticky components of the CPI basket (e.g., housing, recreation, medical care, furniture, education) versus flexible items that change in price more frequently (e.g., new vehicles, gas and electricity, motor fuel, lodging away from home). Both indexes spiked in the 1970s, but today there is a clear divergence between the two.

These components of flexible CPI can certainly have a meaningful impact on consumer sentiment and discretionary spending. However, as figure 5 displays, since the 1990s flexible CPI items have proven that they can rise — and eventually moderate — without negatively impacting growth or becoming a headwind to equity and credit markets, as we’ve witnessed in 2021.

Figure 4: Unlike in the 1970s, inflation and the unemployment rate are trending in different directions
Figure 5: Only prices of flexible items are spiking today
Figure 6: Asset classes have different sensitivities to inflation

Prepare portfolios for inflation above pre-pandemic levels, not for stagflation

The majority of investors — particularly those who are retired and perhaps living on fixed budgets — are equally concerned about their savings eroding in the near-term as they are about outliving their savings in the long-term.1 Portfolios should be constructed to address both these concerns by diversifying across assets that can perform in a range of economic environments, regardless of the near-term inflation outlook. That means allocating to strategies that can provide real, after-inflation returns during deflationary environments (column 1 in figure 6), periods where inflation is closer to its long-term trend (2 and 3) as well as periods where inflation is elevated and rising (4).

At the extremes (columns 1 and 4), daily liquid risk assets generally do not fare particularly well after inflation. This is to be expected, as investors collect a risk premium (total return or income) for owning assets that will periodically experience drawdowns during challenging economic environments.

But these time periods are outliers, representing only a fifth of all quarters over the past 33 years, and markets do recover. While inflation might remain above trend in 2022 (something more akin to column 3), we believe this has already been priced into the markets. Therefore, we don’t believe this is the time to overweight conventional inflation hedges like TIPS or commodities which have already performed well in response to the recent acceleration in consumer prices and today offer negative carry (income yields below the rate of inflation). Perhaps most importantly, now is not the time to be overweight cash, which may be a way to mitigate near-term volatility but not without hindering the portfolio’s real return potential and long-term purchasing power.

Investment ideas: preparing portfolios to guard against inflation risks

There are two ways to generate real returns in an inflationary environment: I) own positive carry investments that generate an income rate higher than the rate of inflation, and II) own investments that tend to experience positive price appreciation in response to inflation.

The first category is harder to come by these days in traditional fixed income, but opportunities still exist. We have a favorable outlook for owning lower-quality fixed income sectors that can better withstand a gradual rise in interest rates, such as floating rate loans and preferred securities, particularly those with fixed-to-float coupon features. The prospect for higher marginal U.S. tax rates should continue to support flows into the tax-exempt space, benefiting high yield municipals.

As for the second category, public equities over the past 30 years have lived up to their reputation as a hedge against moderately higher inflation and should continue to do so. Heading into 2022, our equity team is favoring sectors with a cyclical tilt that should benefit as the rest of the developed world catches up to the U.S. economic reopening, and are more favorable on a valuation basis, such as non-U.S. developed equities and U.S. small caps.

What about strategies that have the potential to fall in both categories? For investors who do not require 100% of their portfolio to be invested in daily liquid strategies, private markets can provide more stable real returns and competitive distribution yields over public market equivalents. Private real estate stands out as a category that can fill this role. While inflation has different implications depending on the geographic region and property type, most long-term leases have built-in rent escalators that are tied to inflation, which protects the income generation of in-place leases.

Bottom line: Expect (but don’t overreact to) elevated inflation and higher interest rates

Our bottom-line view about rising rates and high inflation: We think markets have mostly priced in the likelihood of elevated inflation in 2022 and Fed tightening. Public equity and credit markets can still thrive in environments of low-but-climbing rates and elevated inflation. Real assets and real estate remain important inflation hedges in addition to their fundamental attractiveness.

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Endnotes

Sources

1 Cerulli Report, U.S. Retirement End-Investor 2019.

This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her financial professionals.

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index.

A word on risk

Equity investments are subject to market risk, active management risk, and growth stock risk; dividends are not guaranteed. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. The use of derivatives involves additional risk and transaction costs.

Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, derivatives risk, income risk, and other investment company risk. As interest rates rise, bond prices fall. Credit risk refers to an issuer’s ability to make interest payments when due. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Foreign investments involve additional risks as noted above.

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