Download The Return of Inflation…and Growth?

ETF INVESTMENT
STRATEGY & INSIGHTS
The Return of Inflation…and Growth?
January 2017
Donald Trump took the world by surprise when he won the U.S. election to become
the 45th President of the United States. While it will be weeks or months before the
new administration will be able to implement major initiatives such as tax or
healthcare reform, markets are already responding to expectations that those policies
will result in stronger economic growth. The U.S. equity market has rallied, yields
have spiked, and the USD has strengthened. At the same time, a byproduct of those
policies could be higher inflation and investors are once again focused on inflation
expectations.
Heidi Richardson
Head of Investment Strategy
for U.S. ETFs
Heather Apperson
Investment Strategist for ETF
Investment Strategy & Insights
Summary
Economic conditions in the
U.S. have been improving and
inflation has been trending
upward. While stronger
economic growth presents
potential opportunities in select
equity markets, investors may
also consider protecting their
assets from rising inflation by
owning TIPS or commodities.
Inflation Basics
In its basic form, inflation is the
persistent rise in the price of a particular
good or service. Simply put, a dollar
today may not be worth a dollar
tomorrow. Within the U.S. there are two
primary baskets of good and services
used to measure changes in prices.
The Core Consumer Price Index (CPI)
is intended to capture all goods and
services less energy and food.
Whereas, headline CPI includes the
components with in Core CPI, as well
as the more volatile consumer
expenditures like energy and oil.
To be sure, there are still some unknowns with the new administration’s agenda and
whether the policies pursued will receive Congressional support. But inflation has
gradually picked up and there’s a probable chance the Fed may overshoot its 2%
target irrespective of Trump’s policies, given an already improving U.S. economy, low
unemployment, and increased wage growth (see figure 1). Trump’s proposals to
reduce taxes, repatriate assets, increase infrastructure spending, and pursue
deregulation in many industries have the potential to increase economic and job
growth, and with it, inflation. Whether they will pass and to what degree remains a
game of wait and see.
Investors may want to consider the potential impact of the Trump administration
policies on their portfolios. With respect to the possibility for higher growth, that means
looking at the potential for a continued rotation out of bonds into stocks, and parts of
the equity market that could benefit from Trump policies. Meanwhile, as a precaution,
investors may want to explore adding inflationary hedges to their portfolios. While we
anticipate inflation to rise from current levels, we expect inflation to settle at around
2.5% in the medium term.
Figure 1: U.S. wage growth and core inflation
3
YoY change (%)
Authors
2.5
2
1.5
1
2011
2012
2013
Average Hourly Earnings
2014
2015
2016
Core CPI
Source: BlackRock Investment Institute, Thomson Reuters, as of 12/14/2016
Reflation rotation
The post-election “Trump rally” has been pretty significant with a striking rotation out
of bonds and into sectors expected to benefit from reflation and looser regulation such
as financials, healthcare, industrials and materials. Clearly, investors are assuming
much more robust growth than we’ve seen in recent years, and that some specific
sectors will benefit either from less regulation or new infrastructure projects.
However, we would advise some caution and selectivity for 2017
as many asset classes will be subject to volatility around the
progress President Trump makes with his fiscal policy plans,
deregulation, and immigration just to name a few. Given the
improving U.S. economy and the Fed back on the road to rate
hikes we prefer cyclical exposures like financials and value over
bond-proxies like consumer staples and utilities.
population means higher demand for healthcare services) and
the November deal reached by OPEC to curb production by 1.2
million barrels a day, there’s a high likelihood that healthcare and
oil will continue to drive inflationary pressures in the U.S. While a
modest rise in inflation over time is generally a positive sign that
an economy is growing, it can impact one’s investments and lead
to erosion in purchasing power. Although inflation is still at low
levels, investors may want to consider potential inflation hedges
for their portfolios. Those include TIPS, commodities, and select
equity exposures.
Inflation rebounds
Recently, increases in costs of shelter, healthcare, and services,
as well as oil have driven headline Consumer Price Inflation (CPI)
(see figure 2). Given changing demographics (an aging
Figure 2: Recent stabilization of energy prices could continue to support headline inflation
6
YoY change (%)
4
2
0
-2
-4
2007
2008
2009
2010
Core
2011
Food
2012
Energy
2013
Headline CPI
2014
2015
Source: BlackRock Investment Institute, Thomson Reuters, as of 12/22/2016
TIPS
Figure 3: A breakdown in yields
A common means of protecting one’s portfolio from inflation is by
investing in Treasury Inflation Protected Securities (TIPS). The
principal of a traditional bond is not adjusted for inflation. With
TIPS, the principal itself is indexed to the U.S. headline CPI with
a lag. The percentage of the coupon stays the same but the
dollar amount received will reflect the level of inflation, as it’s
calculated off of the principal amount that is adjusted for inflation.
So the principal and essentially coupon dollar value increases
with inflation and decreases with deflation. To determine whether
current conditions warrant using TIPS, investors often look at
inflation breakevens, which can be thought of as a market-based
measure of inflation expectations (see figure 3).
4
Breakevens measure the average annual inflation needed over
the life of the TIPS in order for it to provide the same return as a
Treasury or nominal bond with the same maturity. Inflation
breakevens can be calculated by taking the difference between
the nominal yield and the real yield of a bond.
3
Yield (%)
2
1
0
-1
-2
2012
2013
2014
2015
10-year inflation breakeven
10-year US nominal
10-year TIPS
Source: Thomson Reuters, Bureau of Labor Statistics, as of 12/14/2016
2016
Historically, commodities have been highly sensitive to changes
in inflation and the business cycle (see figure 4). They tend to
perform best during periods when inflation is rising or stabilizing,
which typically corresponds with expansionary or early
contraction periods in the business cycle. However, when
inflation is declining in the latter contraction phase of the
business cycle, commodities have historically underperformed
both stocks and bonds.
A common question investors have is whether they should invest
in long- or short-term dated TIPS. One’s expectation of nominal
and real (after inflation) interest rates should drive this decisionmaking process. In general, if an investor believes that both real
interest rates and realized inflation will increase, a short-term
TIPS instrument will provide the same realized inflation capture
as longer-dated TIPS but with less interest rate sensitivity.
Conversely, if an investor believes that an increase in nominal
rates (excluding inflation) will be driven mainly by the market’s
expectation for inflation and that real rates will remain relatively
stable, longer-dated TIPS may provide a higher real yield than
short term TIPS, potentially allowing for greater total return.
Commodities
Another potential means of hedging against inflation is through
commodities. Because commodity prices usually rise when
inflation is accelerating, they may offer protection from the effects
of inflation. As demand for goods and services increases, the
price of goods and services usually rises too, as does the price of
the commodities used to produce those goods and services.
In addition, commodities have historically been a low correlated
asset class relative to stocks and traditional bonds making them
attractive from a diversification standpoint. In recent periods, the
correlation between stocks and bonds has steadily risen, thus
reducing the portfolio diversification benefits that treasuries once
provided. This, along with the potential rise in demand for raw
goods due to increased fiscal spending, suggests this may be an
attractive time to invest in commodities.
Figure 4: Performance over different business cycles & inflationary periods
40%
80%
62%
30%
27%
22%
20%
20%
16%
10%
6%
40%
6%
0%
-10%
Average annual return
14%15%
Average annual return
60%
34%
25%
28%
23%
20%
13%
7%
6%
3%
0%
-1%
-4%
-20%
-20%
-22%
-40%
-30%
-44%
-40%
-60%
Declining
Inflation
Equities
Stable
Inflation
Fixed Income
Rising
Inflation
Early
Late
Early
Late
Expansion Expansion Contraction Contraction
Commodities
Source: BlackRock, Morningstar data from September 1994 to September 2016. Equities represented by S&P 500, fixed income represented by Barclays US Aggregate,
commodities represented by Bloomberg Commodity Index TR, and real estate represented by the Dow Jones US Real Estate Index. Business cycle expansion and contraction
phases from National Bureau of Economic Research (NBER) divided into equal halves to indicate early / late phases. Past performance does not guarantee future results.
Bloomberg data from September 1994 to September 2016. Inflation periods defined by CPI monthly changes by more than 31 bps from the median change of 19 bps.
Investment considerations
Investors looking for inflationary hedges may consider investing in treasury inflation protected
securities through iShares:
iShares TIPS
Bond ETF
TIP
STIP
iShares 0-5 Year
TIPS Bond ETF
Investors looking for commodity exposure my consider the following funds:
COMT
iShares
Commodities
Select Strategy
ETF
Investors looking for exposure to the reflation rotation may want to consider the following:
IYF
iShares U.S.
Financials ETF
VLUE
iShares MSCI USA
Value Factor ETF
Want to know more?
iShares.com
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