WATCH OUT FED, YOU MIGHT GET WHAT YOU’RE AFTER
Recent inflation statistics demand continued monitoring, but a surge in recent numbers can be partially explained by certain transitory components upon closer examination. We’re not ready to jump to any conclusions, but we will be paying close attention to upcoming Federal Reserve (Fed) communications for any clues about potential changes in monetary policy.
The April consumer price index (CPI) report was expected to illustrate this dynamic and it did not disappoint, as readings for the month printed at levels that hadn’t been seen in many years. The headline figure of 4.2% was the highest year-over-year figure since 2008, while the less volatile core (ex-food and energy) measure rose 3.0%, which was a figure not seen since the mid 1990’s (Figure 1). These statistics were well above consensus expectations, exacerbated by both supply chain issues as well as a more robust reopening impact than expected. However, when taking a deeper look at the components of the April report, the sectors that had the largest influence in the monthly figure were used cars, airfare, hotel lodging and auto rentals, which collectively contributed the bulk of the core measure’s monthly increase (Figure 2). Given the supply and demand imbalances unique to these sectors, it is reasonable to expect this will be a temporary surge that will normalize later this year as supply constraints ease. It is also worth noting prices in many of the reopening and travel-related categories remain below pre-crisis levels, so these increases are reflective of a healthy return to pre-pandemic levels.
Figure 1. CPI vs. Core CPI
Both headline and core CPI figures have moved to postfinancial crisis highs.
As of 04/30/21. Source: Bloomberg L.P
We believe this is all consistent with the transitory narrative the Fed has been forecasting related to inflation; however, it does warrant attention given the degree of the upside surprise, as well as the anecdotal stories of input shortages and persistent bottlenecks intensifying supply chain concerns (Figure 3). How forward-looking inflation expectations evolve in the coming months will be of utmost concern to the Fed given the high levels of uncertainty related to the unique drivers of the current situation. While having expressed comfort with an inflation “overshoot” given lower-than-desired inflation following the financial crisis, the Fed will need to be mindful of its credibility should inflation expectations become untethered (Figure 4).
Used vehicle prices have soared as the availability of new cars has declined due to a semiconductor shortage.
As of 04/30/21. Source: Bloomberg
Commodity input prices have experienced a sharp rise recently as well.
As of 04/30/21. Source: Bloomberg
Inflation measures will almost certainly remain elevated and be quite volatile in the coming months but given the unique circumstances of the current economic environment, it is important to be mindful of the underlying components of inflation for a truer picture of the overall story. When taken together with other economic data, namely the disappointing April payroll report, the Fed may have some time to remain patient. However, the Fed appears aware of the fluid nature of the current environment, as evident by this notable mention from the minutes of the April Federal Open Market Committee (FOMC) meeting: “A number of participants suggested that if the economy continued to make rapid progress towards the Committee’s goals, it might be appropriate at some point in coming meetings to begin discussing a plan for adjusting the pace of asset purchases.” Perhaps it is finally time to start talking about talking about an adjustment to monetary policy. We will continue to look for clues in Fed communications, including upcoming FOMC meeting minutes (June and July) and the Jackson Hole symposium that has recently been a forum for communicating these types of changes.
The University of Michigan expected inflation rate over the next 5-10 years is well above the Fed’s long-term estimate.
As of 05/21/21. Source: Bloomberg L.P
Figure 5. TIPS Breakeven Rates
The breakeven rate between nominal U.S. Treasuries and
TIPS has continued to rise since bottoming early last year.
As of 05/21/21. Source: Bloomberg L.P
Presentation of Performance of Market Indices
Various market indices may be referred to in these materials. Please see following for a brief description of these indices and comparisons. Indices are unmanaged and not available for direct investment. The performance of an index does not reflect expenses associated with the active management of an actual portfolio.
- The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
- The Core Consumer Price Index (Core CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services, excluding food and energy.
- The Manheim Used Vehicle Value Index is recognized by financial and economic analysts as the premier indicator of pricing trends in the used vehicle market.
- The Commodity Research Bureau BLS/US Spot Raw Industrials Price Index is a measure of price movements of 22 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. As such, it serves as one early indication of impending changes in business activity.
©2021 The PNC Financial Services Group, Inc. All rights reserved.
INVESTMENTS: NOT FDIC INSURED-NO BANK GUARANTEE – MAY LOSE VALUE
Next we examine each of these sectors in more detail.
We focused our analysis of the corporate credit sector on investment-grade securities, defined as BBB-rated and above. The profile of the corporate credit index can be deconstructed into two primary factors that describe risk and return: default risk and spread duration risk. We define default risk across three quality buckets: AAA-AA, A, and BBB. These ratings represent the average rating assigned between the primary credit rating agencies. Similar to modified duration, which measures a bond’s price sensitivity to changes in yields, spread duration measures price sensitivity to changes in credit spread. We believe it is a good proxy for duration risk of excessreturn, as opposed to duration risk of totalreturn (modified duration).
The table below shows excess return, volatility, and MIRs over various credit quality and bond maturity segments.
CORPORATE CREDIT Continued
Modified Information Ratio (MIR)
Between 1997 and 2019, AAA-rated ABS and agency MBS sectors exhibited significantly less volatility of excess return than nearly all credit sectors, resulting in compelling MIRs. Additionally, there was a low correlation of excess return between structured products and the corporate credit sector over the 22-year period, due in part to the high-quality and shorter-duration profile of structured products relative to the overall credit index.
We believe structured products provide an important source of diversification and can improve the risk-return characteristics of an overall portfolio. The diversification benefit provided by incorporating structured products in an asset-allocation strategy can be illustrated by comparing two portfolios, one consisting solely of government and credit sectors (Bloomberg Barclays Government Credit Index) and the other that includes structured products (Bloomberg Barclays Aggregate Index).
As shown in the following table, adding structured securities to a government-credit portfolio over the period 1997 to 2019 would have produced an enhanced average annual excess return, a reduction in return volatility, and a higher MIR.
When constructing a portfolio, there are additional aspects of the MBS and ABS sectors to consider.
STRUCTURED PRODUCTS Continued
OUR COMMITMENT TO OUR CLIENTS
We believe opportunistic sector allocation, coupled with an investment process focused on risk management and identifying relative value opportunities should result in consistent risk-adjusted returns over a full market cycle.
Over the last several years, we’ve experienced a wide variety of interest rate and risk regimes. We’ve adhered to the tenets of our risk-based philosophy throughout and used these opportunities to evaluate the findings of our historical analysis in practice.