Fears of runaway inflation are overblown
For many investors in the United States today—and anyone under the age of 40—inflation feels like something of a relic: a 20th century problem that’s been essentially eliminated. While that may be an attractive idea, the reality is that inflation always has the potential to return under the right combination of conditions—and if there were ever a time to expect an increase, now is probably it. After 12 months of lockdowns and households sitting on record amounts of cash—not to mention a whole menagerie of ongoing supply chain disruptions—some jump in prices was likely inevitable.
But we ultimately believe the current uptick is, as the U.S. Federal Reserve (Fed) likes to say, transitory—the result of too many dollars chasing after too few goods. Although admittedly this transitory period may last longer than consumers would prefer and could prove a rough storm to weather, there are a variety of factors that suggest rampant inflation is unlikely—the labor market being one of them. With unemployment still at elevated levels, it’s hard to imagine big jumps in wages fueling further rises in inflation levels.
The central question for investors, though, isn't about the outlook for inflation, per se, but rather how to position their portfolios for today’s market.
A steeper yield curve comes with benefits
As bottom-up investors, we’re not in the business of making macroeconomic predictions; rather, we respond to those forces if and when they materialize in security-level fundamentals. One area that’s been clearly affected by inflationary forces is the shape of the yield curve, which has steepened considerably since the beginning of the year. Longer-term rates are roughly 60 to 70 basis points (bps) higher now than they were in January for bonds with maturities of seven years or more. But shorter-term yields haven’t budged at all; the Fed has been steadfast in its commitment to keeping the federal funds rate low until the economy has fully recovered, and the short end of the yield curve still reflects that.1
Longer-term Treasury yields are up, while the short end of the curve remains firmly anchored
U.S Treasury rate movements year to date through May 2021
Source: U.S. Department of the Treasury, as of 5/28/21.
While rising rates are often a headwind, a steeper yield curve historically has actually presented more opportunities for active managers. Consider that currently there's a nearly 50bps difference between the yield on a 5- and a 7-year Treasury; sacrificing that income in an attempt to shorten a portfolio’s duration could have a meaningful impact on returns—particularly if rates don’t rise as dramatically in the future as they have this year to date.1 Playing defense when it comes to interest rates almost always comes with an opportunity cost, and we think dramatically shortening duration at this point in the credit cycle would be an overreaction.
Today’s market can offer opportunities for active managers
We’ve said it before, but it bears repeating: Non-Treasury segments of the bond market are driven by both rate changes and perceived credit risks, and in varying proportions. Rather than a signal to run to the sidelines, rising rates have historically been an indication of an improving economy, which is certainly the case today, and corporate bonds tend to perform well in such an environment. Today, there are still a number of sectors and issuers that stand to benefit as the U.S. economy fully reopens this summer, and we think valuations haven't fully caught up with that potential.
Meanwhile, there are certain segments that look relatively less appealing; agency mortgage-backed securities (MBS) are one such example. In the early days of the COVID-19 pandemic, the Fed reinstituted a version of its quantitative easing purchase program, and today, that segment of the market appears relatively overbought. The option-adjusted spreads in agency MBS, particularly given heightened prepayment activity on the underlying mortgages, appear relatively unappealing, in our opinion, and we think better opportunities exist elsewhere.
That said, those pockets of opportunity that do exist in today’s market require a research-driven process to uncover, in our opinion. We don’t believe that now is the time to be either stretching for yield or playing strictly defense by dramatically shortening duration; rather, active managers can add value by targeting undervalued segments of the market and picking up incremental yield on the margins while also rotating away from those segments that appear too richly valued. Higher near-term inflation and a steeper yield curve may not feel like auspicious signals for investors, but they can sometimes be the price of a rapidly growing economy. In a market supported by improving fundamentals and accompanied by some disparate valuations between various segments, we think the best course of action is to focus on the long term rather than make dramatic portfolio changes in response to what may prove to be passing short-term market conditions.
1 Federal Reserve Bank of St. Louis, as of 5/31/21.
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