Last week’s policy address from President Biden confirmed several economic tailwinds for 2021. Accelerating vaccine distribution should lift restrictions on activity globally, allowing spending, hiring, and travel to resume. Fiscal support should promote higher spending and economic activity. Monetary support has kept market liquidity intact and contributed to stable market functioning throughout the year.

Accelerating economic growth is a key driver of higher company profits – good news for investors. At the same time, higher economic growth tends to promote higher inflation, a force that’s felt distant in many of the years since the Global Financial Crisis. If inflation really is on the way, it would have major implications for asset allocation in 2021.

 

Inflation expectations are rising as economic growth expectations improve

5 year, 5-year forward inflation expectation rate

Sources: New York Life Investments Multi-Asset Solutions, Federal Reserve Bank of St. Louis, 01/15/21. Past performance is no guarantee of future results.

 

Inflation concerns are “crying wolf,” at least for now.

We are not concerned about inflationary pressures this year, for several reasons:

  • We will see inflationary pressures this year, but they are transitory. Higher energy prices, seen in December’s inflation number, or a recovery from a month of particularly low inflation, which we expect later this spring, are examples.
  • Some investors point to the enormous scale of monetary policy support and suggest that higher inflation rates will soon be on their way. We are not so sure. Inflation expectations, although relatively well-anchored, moved lower for several years before the pandemic hit. Even as government policy rapidly increases money supply, the velocity of that money in the real economy has declined, meaning it’s not systematically passed to consumer prices.
  • Due to COVID-19, policymakers are fighting an uphill battle against demand destruction, which is outpacing monetary transmission and creating disinflationary pressures for the U.S. economy.

 

If the economy couldn’t generate meaningful inflation pressure at 3.5% unemployment, how would it do so at 6.7% unemployment and declining labor force participation?

 

Will the Fed react to rising inflation?

Just because we’re not worried about inflationary pressures in 2021 doesn’t mean they won’t play an important role in asset allocation. In fact, we consider inflation-related concerns to be a key risk for investors this year.

The central reason investors watch inflation is because of its influence on the U.S. Federal Reserve. The Fed has provided swift and sizable support for capital markets over the course of 2020, and investors are understandably concerned about what will happen if that liquidity support fades. The example of 2013’s “taper tantrum,” which contributed to a stronger U.S. dollar, lower energy prices, and a manufacturing recession, is top of mind.

It is certainly possible that the economy could experience durably higher inflation in 2021. If everything goes right – vaccine distribution accelerates, fiscal support proves sufficient or even overkill, and the economy churns back to life – inflation could move durably higher. If that’s the case, the Fed will start to reconsider its mix of policy support.

That said, the bar for a Fed response is very high. Inflation would not only need to rise; it also would need to reach and even pass the Fed’s 2.0% target. The Fed would have to be confident that those inflationary pressures would last. The labor market, experiencing substantial slack from the COVID-19 slowdown, would have to move back towards maximum employment. Even with the strong economic tailwinds we expect for 2021, this would be a lot of progress to expect in one year. 

As a result, we believe the earliest we could see the Fed signaling a rollback of its quantitative easing program is the end of 2021. More likely than not, this is a 2022 risk.

But, of course, that doesn’t mean markets will be quite so sanguine about the Fed’s support. Investors should expect rates and even equity market volatility this year as moments of higher-than-expected inflation and a steepening curve raise fears of a Fed drawback.

Given the sheer scale of existing policy support, we expect drawbacks to be brief. However, investors focused on capital preservation may consider building resiliency to this volatility and considering cross-asset sources of income.

 

Bottom line for rates, and how to invest

Alongside bouts of higher inflation, we expect a steepening curve to play an important role in asset allocation this year. While curve-steepening moments may be brief, they will prompt questions of the future of rates and the tradeoffs between stocks and bonds in a portfolio. 

 

A steepening treasury curve has implications for asset allocation

U.S. 10Y - 2Y Yield

Sources: New York Life Investments Multi-Asset Solutions, Bloomberg LP, 01/15/21. Past performance is no guarantee of future results.

We don’t expect U.S. treasury rates to move substantially higher over the course of 2021. The factors contributing to the “lower for longer” rates environment are still very much intact, and the related global search for yield is likely to mean plenty of demand for U.S. duration assets. Our portfolios are positioned neutral in duration.

Still, we expect investors to begin reconsidering their bond portfolios in 2021. Investors concerned about rising inflation could consider cyclical asset classes such as bank loans, short duration, and high yield. Inflation-linked bonds are another option, offering a direct inflation hedge, but also benefiting if real rates – yield minus inflation – fall. Given the substantial uncertainty that remains, careful credit analysis is essential to navigating the environment ahead.

Real assets are another potential inflation hedge. We particularly like infrastructure as an asset class given the strong policy tailwinds likely underway in the United States. 

 

This material represents an assessment of the market environment as at a specific date; is subject to change; 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 regarding any funds or any particular issuer/security. 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.

Any forward-looking statements are based on a number of assumptions concerning future events and although we believe the sources used are reliable, the information contained in these materials has not been independently verified and its accuracy is not guaranteed. In addition, there is no guarantee that market expectations will be achieved.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company.

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