Inflation risks have started to come into focus

November 15, 2018

Since the global financial crisis that ended in early 2009, inflation has been low and inflation-sensitive assets have underperformed.

Expectations have recently picked up for inflation, and inflation-sensitive assets may therefore be poised to have stronger performance.

Considering the challenging environment for inflation-related assets in recent years — as evidenced by depressed break even spreads, negative real yields, and the underperformance of inflation-linked versus nominal bonds — it’s fair for investors to ask “Is inflation dead?” However, it is interesting to note that inflation risks have started to come into focus in recent quarters, and the outlook for inflation-sensitive assets may be improving. For example, mounting inflation pressures have been reflected in the U.S. consumer price index since the end of 2015 and in the producer-price index since the end of the following year. And while the U.S. labor market has endured a steady but painfully slow recovery since the global financial crisis ended in early 2009, it is now showing signs of substantial tightening; full or near-full employment could eventually put more upward pressure on prices, especially if wage and other employment costs finally start to accelerate. And while crude oil, as measured by West Texas Intermediate Crude Oil prices, have slumped recently they remain more than double their lows of 2016.

Exhibit 1: Trends affecting inflation

Exhibit 1: trends creating upward pressure on inflation

Sources: Bloomberg, SEI. Data as of October 31, 2018.

In 2018, after a protracted period of generally lackluster performance of inflation-related assets, investors have been increasingly focused on inflation risks. This can be seen in Exhibit 2, which illustrates that inflation breakeven spreads have trended steadily higher since the end of 2015 — bringing them back in line with their long-term averages (spreads remain a bit higher for nearer-term, five-year break-even spreads).

Exhibit 2: Recovery expectations

exhibit 2: recovery of inflation expectations

Sources: Bloomberg, SEI. Data from January 2003 through October 2018. Inflation breakeven spreads are the difference between yields to maturity on nominal and inflation-linked Treasurys of the same or similar maturities.

We believe it’s important to maintain a strategic allocation to inflation-sensitive assets rather than try to time inflation.

When it comes to building strategic portfolios, much of the investment industry appears to regard inflation-sensitive assets as a less critical component compared to traditional stocks and bonds. Yet at SEI, we believe that inflation-sensitive assets play a crucial role in strategic portfolio construction. But we do not believe that investors should try to time allocations to inflation-sensitive positions; it is impossible to accurately time major inflation-sensitive asset allocation shifts, just as it is for all other asset classes. While no one can predict shifting market expectations for anything, including inflation, we can try to prepare our portfolios for that eventuality. As such, there are indications that the inflation-sensitive assets in SEI portfolios could come into focus sooner rather than later.

We are not making an inflation call. Rather, we are highlighting our view that owning inflation-sensitive assets is a crucial part of diversified, strategic portfolio construction.

A strategic allocation to inflation-sensitive assets should improve a portfolio’s ability to weather whatever the markets may throw at it. This is not an inflation call or forecast — it is simply a reminder that the future is never certain, that most financial assets are negatively exposed to inflation, and that inflation risk (while missing in action the last several years) should not be presumed dead.

Legal Note

Important Information
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.
There are risks involved with investing, including loss of principal. Diversification may not protect against market risk.
Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI
Investments Company. Neither SEI nor its subsidiaries is affiliated with your financial advisor.
Index returns are for illustrative purposes only and do not represent actual fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
The performance data quoted represents past performance. Past performance does not guarantee future results.