Inflation TIPS for Fixed-Income Investors
What happens when you combine the tipping point of two deflationary forces—globalization and demographics—with a pandemic, epic supply-chain disruptions and an invasion in Europe? Inflation of a magnitude not seen since the 1970s. Some of the contributing factors may be transitory, but not all, and lingering inflation is likely to be higher than before. How should bond investors adapt?
Inflation Is a Process, Not an Event
For decades, strong deflationary forces held sway over the global economy. Demographics shifted as the working-age population swelled and women’s participation in the labor market increased. Workers from China, India and other emerging-market countries effectively doubled the global workforce. Combined with technological innovations and associated productivity enhancements, the larger workforce helped moderate price growth.
Until very recently, the US economy had been enjoying what felt like an economic party— inflation was moderate, the Fed was spiking the punchbowl with easy money, interest rates were low and growth investments danced with lamp shades on their heads.
But tides turn. The deflationary demographics tailwind is abating. Baby Boomers are edging into retirement, and US family size is dropping. And there are no sizeable pockets of workers unconnected to the global supply-chain. Globalization isn’t just slowing; it’s shifting into reverse. A call to bring supply-chains back onshore began even before the pandemic revealed the vulnerabilities of extended supply-chains.
Add to this pandemic-related stimulus. Consumer savings increased as they had limited opportunities to spend, especially on services. Factories closed for population distancing, creating backlogs that could take years to clear. And resulting supply chain disruptions left some retailers with sparse inventory.
This shortage of available goods combined with pent-up demand has triggered tangible widespread inflation. Durable goods prices have soared by almost 17% year over year through December 2021. Services prices are also increasing—albeit more slowly—as consumers emerge from pandemic isolation. And labor costs are rising, as many workers can’t or don’t want to return to the traditional labor force.
The Fed’s task is to take away the punchbowl before inflation gets out of hand by raising interest rates, but with setbacks from the pandemic, the timing has been tricky. A year ago, the market expected inflation of 2.4% annualized over the next five years. Today, the market is pricing in over 3.25%. And Russia’s invasion of Ukraine is pushing inflation expectations even higher, driven by soaring oil and grain prices. The conflict could increase the duration and intensity of inflation.
Inflation can bruise traditional stock and bond portfolios’ real (inflation-adjusted) returns. Historically, when inflation spiked, the 10-year rolling real return of a 60% stock / 40% bond portfolio turned negative (Display).