Uptick in Inflation Presents Opportunities

by:
Chief Portfolio Strategist, MainStay Investments

Recent inflation data was lower than expected. Now, some of this reflected cell phone plans and a mid-March storm in the Northeast. Beneath it all, the story of inflation slowly rising may not be over. The NY Fed’s Survey of Consumer Expectations shows a three-year ahead expected rate of inflation of 2.7%. China’s economy is growing, with the most recent data showing 6.9% growth. OPEC members have recently been talking about $60 a barrel of oil, and monetary policy is accommodated at the global level.

Now, an uptick in inflation is one of our investment themes for this year. The Fed’s favorite measure is shown here, and it is moving towards its goal of 2%.

Figure 1 – Core Personal Consumption Expenditures (PCE) Index, Year-over-Year (%)

Source: Bloomberg, as of 4/13/2017. Last data point is 2/28/2017.

Investors seeking opportunities resulting from an uptick in inflation may want to consider commodity-related exposures or an exposure to the U.S. Energy-Renaissance that’s underway. Now, it’s hard to value commodities using the metrics we deploy on stocks and bonds, but we can compare commodity prices to consumer prices, and when we do that, as shown here, commodity prices are low by historical measures.

Figure 2 – Historical Ratio of the S&P GSCI Index to CPI vs. Its Average (1990-2017)

Sources: Thomson Reuters Datastream, New York Life Investments, 12/15/16. The S&P GSCI (formerly the Goldman Sachs Commodity Index) serves as a benchmark for investment in the commodity markets and as a measure of commodity performance over time. The Consumer Price Index (CPI) produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. Past performance is no guarantee of future results. It is not possible to invest directly in an index. Index definitions can be found at the end of this seminar.

Here is another angle to consider. As inflation inches up, consumers and businesses are likely to worry less about deflation. Now, it may be hard to believe right now, but the “d” word was a pretty big concern not all that long ago. And, a gradual uptick in inflation also lowers the real or inflation-adjusted Fed Funds Rate that you see here. Again, this is a very accommodating reading; we expect the Fed to raise rates two more times this year as a base case scenario.

Figure 3 – Real Fed Funds Rate Using Core PCE Year-over-Year (%)

Source: Bloomberg 4/13/2017. Last data point is 2/28/2017.

Speaking of rising rates, a rising rate environment is another of our themes for 2017. As a result, we are favoring opportunities in credit. Historically, floating rate notes, high-yield and short-duration high-yield strategies have outperformed investment-grade bonds during periods of rising Treasury yields. And, municipal bonds performed well in the 2004-2006 Fed tightening cycle. Past performance is not a guarantee of future results.

Figure 4 – Municipal Bonds Performed Well in the Last Fed Tightening Cycle

Sources: Bloomberg, Morningstar, 12/31/16. For illustrative purposes only. The Municipal AAA yield curve is a fair market value index derived from data points on Bloomberg’s option-free Fair Market Curves prior to 11/13/14. Effective 11/13/14, indices are calculated using BVAL methodology. Past performance is no guarantee of future results. An investment cannot be made directly into an index. Index definitions can be found at the end of this blog post.

Since March 1, the U.S. stock market has been consolidating its prior gains.

Figure 5 – The S&P 500 Index Has Been Consolidating Prior Gains since March 1

Source: Bloomberg, 4/13/2017.

A volatile, single-digit, per-annum return environment is one of our other themes for this year and our base case scenario. Now, the opportunity set that investors have can help. For example, convertible bonds act more like stocks when the equity market is rising and more like bonds when it is not, this hybrid feature may be attractive to investors concerned about volatility. And, liquid alternatives – which include hedged strategies, such as risk arbitrage – can also help diversify a classic stock-bond portfolio.

In short, today’s investment environment poses its challenges, but it also presents opportunities.

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The information contained herein is general in nature and is provided solely for educational and informational purposes. New York Life does not provide legal, accounting or tax advice. You should obtain advice specific to your circumstances from your own legal, accounting and tax advisors.

Barclays U.S. Corporate High Yield Index measures the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. The index excludes emerging market debt.

Barclays U.S. Aggregate Bond Index is an unmanaged market value-weighted performance benchmark for investment-grade or better fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of at least one year.

BoA/ML U.S. Cash Pay High Yield BB-B Rated 1-5 Year Index is a subset of the BoA/ML U.S. Cash Pay High Yield Index including all securities with a remaining term to final maturity less than 5 years and rated BB through B inclusive.

Barclays Municipal High Yield Index is an unmanaged index consisting of non-investment grade, unrated or below Ba1 bonds.

Barclays Municipal Long 22+ Year Index is an unmanaged index that measures the performance of municipal bonds with time to maturity of no less than 22 years.

Barclays Municipal Bond Index covers the USD-denominated long term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.

Barclays Municipal Intermediate 5-10 Year Index is an unmanaged index that measures the performance of municipal bonds with time to maturity of more than five years and less than ten years.

Barclays U.S. Credit Index measures the performance of investment-grade corporate debt and agency bonds that are dollar denominated and have a remaining maturity of greater than one year.

Barclays U.S. Government Bond Index is composed of the Barclays Treasury Bond Index (all public obligations of the U.S. Treasury, excluding flower bonds and foreign-targeted issues) and the Barclays Agency Index (all publicly issued debt of U.S. Government agencies and quasi federal corporations, and corporate debt guaranteed by the U.S. Government).

Barclays 1-3 Year Municipal Bond Index consists of a broad selection of investment grade general obligation and revenue bonds of maturities ranging from one year to four years.

Municipal yield is the income return on an investment, such as the interest or dividends received from holding a particular security.

Personal Consumption Expenditures (PCE), or the PCE Index, measures price changes of consumer goods and services. Expenditures noted on the index include actual expenditures and expenditures that are attributed to households in the United States; data that pertains to services, durables and non-durables is measured through the index.

Consumer Price Index (CPI) represents prices paid by consumers (or households). Prices for a basket of goods are compiled for a certain base period.

S&P 500 is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock market performance.

S&P GSCI (Goldman Sachs Commodity Index) is widely recognized as a leading measure of general price movements and inflation in the world economy.  It provides investors with a reliable and publicly available benchmark for investment performance in the commodity markets, and is designed to be a “tradable” index. The index is calculated primarily on a world production-weighted basis and is comprised of the principal physical commodities that are the subject of active, liquid futures markets.

Treasury yield is the return on investment, expressed as a percentage, on the U.S. government’s debt obligations (bonds, notes, and bills). It is the interest rate the U.S. government pays to borrow money for different lengths of time.

Alternative investments are speculative, not suitable for all clients, and intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investment.

Commodities are investments in instruments and companies that are susceptible to fluctuations in certain commodity markets. Any negative changes in commodity markets (that may be due to changes in supply and demand for commodities, market S-4 events, regulatory developments or other factors) could have an adverse impact on those companies.

Investing in below investment-grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds.

Floating rate funds are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, non-diversification, borrower industry concentration, and limited liquidity. The Fund may invest in foreign securities. U.S. dollar-denominated securities of foreign issuers can be subject to different risks than U.S. investments, including less liquid trading markets, greater price volatility, political and economic instability, less publicly available information, and changes in U.S. or foreign tax or currency laws and monetary policy. High yield securities (junk bonds) have speculative characteristics and present a greater risk of loss than higher quality debt securities. Funds that invest in bonds are subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner.

The value of investments that are concentrated in the global resources sector will be affected by factors specific to that sector and generally will fluctuate more widely than a fund which invests in a broad range of industries. Investments in foreign markets are susceptible to foreign securities risk and will be subject to risk of loss not typically associated with domestic markets. Loss may result because of less foreign government regulation, less public information, less economic, political, and social stability, or other factors. Stock prices of mid-and small-capitalization companies generally are more volatile than those of larger companies and also are more vulnerable than those of large-capitalization companies to adverse business and economic developments. Funds that invest directly in foreign currencies or in securities that trade in, and receive revenues in, foreign currencies are subject to the risk that those currencies will decline in value relative to the U.S. that the U.S. dollar will decline in value relative to the currency being hedged.

All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.

The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.

MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Charlie Reinhard

Chief Portfolio Strategist, MainStay Investments

As head of portfolio strategy at New York Life’s MainStay Investments, Charlie Reinhard leads investment thought leadership and portfolio construction efforts across MainStay mutual funds and IndexIQ ETFs

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