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Resources / Commentary | November 1, 2016
What’s that smell? No political jokes. No celebrity ones either. That smell you smell is the faint whiff of inflation seeping into the economy. It’s also one of the big reasons for the cruel October bond selloff.
Let’s be clear from the start: we are not predicting the hurtling inflation of the 1970s. In fact, despite years of extraordinary efforts by central bankers to push growth and inflation higher, those levels have stayed stubbornly low. However, there are more and more indications of an upward trend in inflation, a risk that markets are not yet fully pricing.
Here are just a few signs:
All these are backward looking statistics, though. What we find even more convincing is the forward-looking inflation outlook as measured by the Breakeven Inflation (BEI) rate. BEI is the difference between yields on 10-year notes and similar maturity Treasury Inflation Protected Securities (TIPS). It marks investor future expectations for average annual consumer-price gains.
BEI hit a low of 1.19% on February 11 this year and has charged all the way up to 1.72% by the last day of October 2016. This translates in an increase in inflation expectations going forward of over 50 basis points, a stealth bull market for inflation.
While inflation is challenging for a number of investment asset classes, there are others that benefit. Notably, TIPS can outperform relative to Treasuries. Infrastructure-related assets have, historically, also provided inflation-hedging. Floating rate loans, as the name suggests, float their coupons with rising interest rates which may also offer a measure of inflation protection. These are all asset classes that we are buying, or warming up to, as we continue to sniff out signs of inflation.
3 Apartment Market Report, September 2016. RentCafe with data provided by YARDI Matrix.
4 College Board: Tuition and Fees and Room and Board over Time.
5 U.S. Average Hourly Earnings: Production & Non-supervisory employees. Bureau of Labor Statistics. BCA Analytics.
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