Inflation Is Not Dead Yet

rubber-bands

After declaring inflation all but gone last summer, investors are now deciding that calling the time-of-death might have been a bit premature. Starting in September and accelerating post-election, 10-year inflation expectations, measured by 10-year Treasury Inflation Protected Securities (TIPS), are surging. Breakeven levels (the difference between a yield of a nominal bond and an inflation-linked bond) are up over 40 basis points (bps, or 0.40%) from the summer low and over 80 bps from the February nadir.

Last October, I suggested that inflation expectations were too low. Despite the recent rally, here are four reasons why I think the rebound in inflation and inflation expectations is likely to continue into 2017.

1. The recent rebound simply represents a reversion to the mean.

While breakevens have moved dramatically, they’ve only reverted to the post-crisis average; 10-year breakevens remain 20-30 bps below where they were in the early summer of 2014. Investors are still not expecting any real pickup in inflation beyond the post-crisis norm.

2. Core inflationary pressures continue to build.

Two of the key components of core inflation, medical costs and housing, are accelerating. Consumer Price Index (CPI) Medical Care is now running at 4.25%, roughly double the level from two years ago. The rise in medical costs appears to be a function of a structural change in deductibles and out-of-pocket expenses. Housing costs also continue to rise. Owners Equivalent Rent (OER) is now running at roughly 3.4% year-over-year, the highest since spring of 2007.

3. Prices on cyclical commodities are spiking.

While oil prices have grabbed the headlines, industrial metal prices are also surging. The magnitude of the increase is almost certainly exaggerated by speculation and a growing preference in China for dollar denominated assets. That said, the change was already underway pre-election. The JOC Industrial Commodity Price Index is up 40% year-over-year. See the chart below for individual metal prices. Historically, there has been a tight correlation between industrial metals and 10-year breakevens, a relationship that has been consistent even in the post-crisis environment.

industrial-metals

4. Most post-election factors point to more inflation.

While the market has undergone a significant recalibration post-election, most of the adjustment simply reverses the decline that began in June of 2015 and culminated last February. In this context, the full impact of the election may not be fully discounted. I see significant potential for fiscal stimulus and potentially trade and immigration disruptions, both of which would add to existing inflationary pressures.

Rising rates have hurt the entire bond complex, since a significant portion of the recent rise has been driven by inflation expectations. Still, TIPS have been outperforming nominal Treasuries and because rising inflation has probably not been fully discounted, this pattern may have further to run. As such, I continue to prefer TIPS to the rest of the Treasury market.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Past performance is no guarantee of future results.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Too Much, Too Little, Too Late?

Business cycles don’t typically die of old age. More often than not, some outside force, such as higher interest rates, snuffs out the expansion. Surely the US Federal Reserve’s intent is not to bring the economic cycle to a close, but that is often the end result of trying to rid the system of risks like excessive financial leverage or runaway inflation. Sometimes the Fed has an accomplice or two, such as an oil shock or a currency dislocation. Whatever the cause, recessions are unwelcome, bringing with them rising job losses, falling financial markets and even bankruptcies.

The end of a business cycle can be tough on investors. Stock and high-yield bond portfolios typically tumble. The average decline in the S&P 500 Index during a recession is 26%, and during the global financial crisis, the index declined nearly 50%. Recessions can be particularly damaging to Main Street investors, as they typically exit the markets after most of the harm has been done and often do not reenter markets until well into the subsequent expansion, when confidence abounds. Poorly timed exit and entry points mean the average investor does not achieve anything like the returns of the major indices. For instance, only now, with markets up 230% from their March 2009 lows, are Main Street investors reentering the market. This begs the question, are they too late again?

Alive and kicking, for now

We’re in the midst of the third-longest business cycle in the post–World War II era. At the moment, even though the cycle is showing signs of fraying, there are no obvious threats to its continued well-being. However, it may pay to be wary of entering the market at this late stage, as risk/reward ratios tend to become unfavorably skewed late in a cycle.

With that in mind, let’s look at our late-cycle checklist.

late-cycle-checklist

Investors may want to take heed of the increasingly worrisome signs indicated above. However, these should be taken as cautionary signs, not a call to retreat. There are also some positive signs afoot. For example, inflation has been late to arrive this cycle, which should allow the Fed to tighten monetary policy much more gradually than would normally be the case. Also, the US labor market continues to slowly improve, suggesting this business cycle will be prolonged. However, there is the risk that the cycle could suffer a slow fade-out. While US personal incomes are rising, health care costs are rising faster, taking away purchasing power, which is impacting consumer-facing sectors such as restaurants and retailers. US business spending remains very weak, and credit conditions are already tightening for certain borrowers. Several market sectors are experiencing profit erosion, which contrasts with the first six years of this business cycle, when margins and profits rose in tandem. US worker productivity is falling, as well, as unit labor costs rise.

Aging expansion vulnerable

While we’re not yet in bubble territory, I’d caution investors that US and European markets are historically expensive on both a price-to-earnings and price-to-sales basis. For example, the Russell 2000® Index is now at a price/earnings multiple of 27. However, I don’t foresee a quick or violent end to this cycle, as we saw in 2008. But I am concerned that late-cycle entrants into risk assets like stocks and high-yield bonds are taking a leap of faith at a time when there is less room for markets to move up and growing risks of them falling back. I do foresee this cycle coming to an end, but not as suddenly or brutally as in prior episodes. This aging expansion, now in its eighth year, weakened by faltering profits, is becoming more vulnerable due to slowly rising interest rates, sluggish consumer spending, shrinking profit margins and rebounding energy costs. Gone are its youthful days of mid-cycle strength.

In the wake of the US election, the retail investor has come back to life. But history tells us that changes in political regimes have relatively modest impacts on the real economy, which obeys only the laws of supply and demand. The signals being sent by the real economy are much more sobering than the signals being sent by a euphoric market. In my view, the odds of a reacceleration in economic growth are minimal at this late stage of the cycle. Retreating slowly from risk is one way to manage today’s ecstatic environment, perhaps by lightening up on historically expensive assets and shifting over time into high-quality corporate bonds or shorter-term fixed income vehicles.

James T. Swanson, CFA is the chief investment strategist of MFS Investment Management.

 

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.

The Latest Risk for Stocks

Inflated balloon surrounded by deflated balloons

Equities continue to grind out new record highs, leaving U.S. stocks expensive relative to both history and other countries. Many investors believe the high valuations are justified given still historically low interest rates and inflation. Unfortunately, the regime may be changing in a way that would be less friendly to elevated equity multiples. One dimension of that change is inflation.

Headline inflation has been rising as oil prices have rebounded. The consumer price index (CPI) is now running at 1.60% year-over-year, double the level in July. This is important for market multiples, which historically have been higher when inflation is lower.

Going back to 1954, the level of the CPI has explained approximately 35% of the variation in the S&P 500’s trailing price-to-earnings ratio (P/E). While the relationship has tended to be less linear with inflation at very low levels, as is the case today, there is another dimension of this relationship that is worth watching: the volatility of inflation.

The relationship between equity multiples and inflation

In the past, equity multiples have been highest when inflation is not only low but stable. Historically, the five-year trailing standard deviation—a measure of volatility—of CPI has explained roughly 30% of the variation in market multiples. The relationship between inflation volatility and multiples holds up even after accounting for the level of inflation. In fact, a model that accounts for both the level and volatility of inflation has explained roughly 60% of the variation in market multiples.

These relationships are important because today inflation is rising and becoming less stable at a time when stocks are particularly expensive. The S&P 500 trades at approximately 20.5x trailing earnings, putting multiples in the top quintile (20%) of all observations going back to the 1950s. Put differently, over the past 62 years the market has only been more expensive roughly 16% of the time. Looking at a longer-term metric, the cyclically adjusted P/E ratio, markets are even more expensive. Based on this metric, which uses longer-term earnings, the market has only been this expensive during the tech bubble or right before the 2008 crash.

cyclically-adjusted-pe

In short, today’s valuations are still supported by low inflation and relatively low rates, but that regime may be shifting. Even if inflation remains low by historical standards, should it start to become unmoored, that would remove another prop supporting equity market valuations. For investors, this suggests two strategies.

First, don’t abandon international diversification. Markets are cheaper outside of the U.S. Second, emphasize more of a bottom-up approach, emphasizing those parts of the U.S. market, notably cyclical companies and health care, where multiples are less stretched.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only.You cannot invest directly in an index.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Weather Forecast, Near 100% Chance of a Rate Hike

Austria, Tyrol, Tannheimer Tal, hiking trail in mountainscape

This week the U.S. Federal Open Market Committee (FOMC) will hold its last meeting of the year. And this time it appears likely that it plans to do something it hasn’t done yet in 2016: raise short-term interest rates. According to Bloomberg, the market is currently pricing in a 100% chance that the Federal Reserve (Fed) will raise rates from the current 0.50%-0.75% range to 0.75%-1.00%. The market’s confidence is driven by recent strong economic data. Job gains have been steady and the unemployment rate has fallen to 4.6%, at the same time the Consumer Price Index (CPI) rate is inching closer to 2% after having spent much of 2015 close to 0% (source: Bureau of Labor Statistics). And overall gross domestic product (GDP) grew a robust 3.2% in the third quarter (source: Bureau of Economic Analysis). All of this looks to have given the Fed confidence that it can go ahead and increase short-term rates, and it has clearly communicated this intention out to the market.

What does a rate hike mean to investors?

This potential increase in short-term interest rates probably won’t have much of an impact on most fixed income portfolios. The forecasted move itself is small, and it mostly affects shorter maturity bonds that do not have as much interest rate sensitivity as longer maturity bonds.

Outside the bond market, there will be slightly higher interest rates for some consumer loans like home equity lines of credit and adjustable-rate mortgages. In return we may see slightly higher interest rates on checking and savings accounts. All in all, we believe the impact for investors should not be significant.

Interestingly, if we look at the capital flows for U.S. fixed income exchange-traded funds (ETFs) in the accompanying chart, there has been quite a bit of activity since the last Fed meeting on November 2.

fi-etf-flows

Although some of the flow activity may be related to the Fed moving closer to raising rates, most of it has occurred since the U.S. election. The new administration has signaled policies such as tax cuts, increased Treasury issuance and reduced regulation that many investors believe could result in higher interest rates, higher inflation and a favorable environment for corporate bonds. Consequently we have seen 10-year Treasury yields rise sharply from 1.86% on November 8 to 2.41% on December 8 (source: Bloomberg data).

Flows since the election have reflected such sentiment. As Treasury rates have risen, investors have pulled back from Treasury securities. At the same time some have moved into TIPs on the expectation of higher inflation. And high yield inflows have been strong on the belief that that sector will continue to perform well. Like EM equities, EM bonds have experienced outflows and poor performance due to concerns about the impact of potentially new U.S. trade policies on emerging economies.

Where should investors go from here?

Investors with shorter-term investment horizons should be cognizant of the impact that rising interest rates have had on their bond portfolios, and be ready for more volatility as the new administration’s policies are implemented beginning in January. But longer-term investors may be best served by sitting tight. Yes, rising interest rates do cause bond prices to fall, and this drags down performance in the short term. Over the long run, however, higher interest rates boost bond fund income payments. Although this may sound counterintuitive, if you are a long-term bond investor, you may actually favor rising interest rates. Higher interest payments may offset the price decline caused by rising rates over time.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

 

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets and in concentrations of single countries.

TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses. Government backing applies only to government issued securities, and does not apply to the funds.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Why the Small Cap Rally May Fizzle

pouring cola into glass with ice and strip straw on table top; Shutterstock ID 391513618

Small cap stocks are having a stellar year with the Russell 2000 Index up nearly 20% year-to-date. In November, small caps outperformed large caps, as measured by the S&P 500, by roughly 9%, the strongest monthly performance in more than 15 years (source: Bloomberg data, as of 11/28/2016). What’s behind the rally — and more importantly, can it continue?

Many have pointed to the strong U.S. dollar to explain the small cap outperformance. The argument is a strong dollar supports America’s purchasing power, which helps smaller, domestically-focused companies while hurting larger, more export-oriented firms. This explanation has intuitive appeal, but it ignores two issues.

HISTORICALLY WEAK RELATIONSHIP BETWEEN THE DOLLAR AND SMALL CAP RELATIVE PERFORMANCE

Since 2000 the relative performance of small caps versus large caps has actually had a low correlation with changes in the dollar. While the correlation was negative at one point, it has historically been weak, explaining less than 1% of monthly relative returns. In short, although commentators have attributed small caps’ outperformance to a rallying dollar, history suggests otherwise.

SURGE IN RISK APPETITE

It is important to note that risky assets in general, not just small caps, have had a brilliant run. That reflects the change in sentiment we have seen. In fact, risk appetite, as measured by monthly changes in credit spreads, has had a much stronger correlation with the small cap relative performance than the dollar’s strength. Since 2000, monthly changes in high yield spreads have explained roughly 10%-15% of small caps’ relative performance.

Can the small cap rally continue?

Going forward small caps face two significant headwinds. First, the small cap rally is more likely to go on if credit spreads continue to tighten. Unfortunately, a stronger dollar is also a de facto form of monetary tightening, and a further rise in the dollar suggests that spreads are more likely to widen than contract.

The second headwind is valuation. The recent rally has occurred at a time when small caps — along with the rest of the U.S. market — are already expensive. Following the recent gains, the Russell 2000 Index is now trading at roughly 47x trailing price-to-earnings (P/E), compared to a five-year average of approximately 39x. And as with the broader U.S. equity market, recent gains have been driven by multiple expansion — investors willing to pay more per dollar of earnings — only more so. Since the lows in early 2016, the trailing P/E on the Russell 2000 is up by more than 40%. In contrast, while large cap stocks have also undergone significant multiple expansion, the P/E on the S&P 500 is up less than 25% from the 2016 bottom. (All data are from Bloomberg, as of 11/28/2016.)

Yes, small caps may continue to advance on other factors, notably an ongoing rally in bank shares (the Russell 2000 has a heavier weighting to banks). That said, a further advance in the dollar, while a headwind for large cap exporters, is not necessarily a tailwind for small caps. Instead, with valuations stretched and 2017 earnings expectations already aggressive, investors are really betting on continued animal spirits and a benign credit market.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.