Mama always said…inflation isn’t microwave safe.
With inflation, you can't just throw it in a microwave, crank up the heat for a couple of minutes, and expect it to come out perfectly cooked and done. Tackling inflation is more like preparing a multicourse meal that requires careful timing, seasoning, and patience. The current inflation environment is proving that with Fed officials, and investors, growing concerned about the lack of progress being made on slowing inflation. While the market is clamoring for rate cuts, we’ll remind our readers of the potential effects of cutting rates too early. The chart below shows that when the Fed cut too early facing the 1970s inflation, it came roaring back reaching new highs.
So, if inflation is sticking around what should I be doing with my portfolio? Well…
Mama always said…diversification is more important when inflation is high.
Lately, stocks and bonds are moving together. Starting in 2021, market dynamics shifted: after nearly 20 years of stocks and Treasury yields moving in sync, their correlation turned negative. This shift means that stocks and bonds, which had been moving in opposite directions due to the inverse relationship between yields and bond prices, are now moving more often in the same direction. As the chart below shows, this behavior isn't new – it was a trend from 1970 to 2000. It's likely a result of higher inflation, which underscores the need for greater diversification. In our view, investors should consider adding a broader range of asset classes, such as infrastructure equity and debt or convertible bonds, which tend to have low correlation with interest rate changes.
How else can I protect against the effects of inflation? Well…
Mama always said…invest where inflation is falling.
Inflation overseas has been less sticky than in the U.S., and this, coupled with steady but slow growth in the euro area and UK, makes markets more confident in rate cuts from the European Central Bank and Bank of England than from the Federal Reserve. Although Japan is also dealing with higher inflation, it is earlier in its economic cycle and attracting foreign capital. In China, inflation isn’t a problem, so the government has ramped up fiscal stimulus, particularly in infrastructure and manufacturing, and markets are starting to react positively. We'd advise boosting equity diversification by adding non-U.S. exposure, but on a hedged basis given that a 'higher for longer' rate environment is bolstering U.S. dollar strength.
Now that I’m well diversified, should I expect smooth sailing ahead? Well…
Mama always said…rate hikes eventually come back to bite.
This suggests it won't be smooth sailing ahead. In the credit markets, debt restructurings are rising, and while healthy companies should handle higher rates, we expect many will struggle. We know that high-yield corporate credit maturities start climbing in 2025 and keep rising until 2029. Spreads are likely to widen as defaults, which hit a low in 2022, continue to rise. While that is a warning for credit markets, it also suggests there is plenty of runway before refinancing risk jumps.
Equities aren't immune to Fed hikes either. As the chart below shows, interest rate hikes typically precede stock market volatility by about 25 months. If this pattern holds, we're looking at more equity market turbulence later this year. That timing aligns with the election cycle, which historically brings heightened market volatility in September and October of election years.
So, with equity volatility likely to rise, should I be buying long bonds instead? Well…
Mama always said…don’t forget about the term premium when buying duration.
Right now, bonds seem attractive at current yields, but we believe the U.S. term premium for the 10-year bond, currently hovering around 0%, is precariously low. No term premium implies that, for instance, investors aren’t demanding extra compensation for holding a 10-year bond versus repeatedly rolling over a 1-year bond nine times. Macro uncertainty in policy and a rising government deficit have helped push the premium lower.
Later this year, as the outlook on Fed rate cuts and government spending becomes clearer, particularly through the election, we could see term premiums rise. In recent years, they've stayed unusually low, often negative, following the financial crisis and pandemic. Historically, however, the term premium on the 10-year yield averaged around 1.5%. Rising premiums could pose a risk to longer-duration assets, which is why we prefer a barbell approach to portfolio construction, balancing short duration with longer-duration municipal bonds to potentially outperform mid-curve duration.
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