• The market has quickly become attuned to the Core, or “Sticky”, Consumer Price Index (CPI) series because it excludes volatile energy prices and yet continues to rise even as headline inflation falls.
• The global bond market is currently in the midst of a rapid regime shift, with the sum of all negative-yielding debt around the world falling from nearly $17 trillion to $2 trillion in less than ten months.
• There may be at least three secular forces putting upward pressure on the trend component of inflation: an aging demographic depending on a proportionately declining working-age population, rising inequality and its backlash of populist political forces and a disjointed energy transition policy agenda.
A Global Bond Implosion
The Bloomberg Global Aggregate Bond Index, which tracks total returns from investment-grade government and corporate bonds, is in a correction for the first time in its history as central banks around the developed world execute rapid interest-rate hikes to combat persistent and broadening inflation. The most recent CPI reading in the US shows that while headline inflation is falling naturally due to declining energy prices, the slower-moving core inflation component is continuing to rise at its quickest pace this cycle.
Bonds have had the highest Sharpe Ratio of all major asset classes over the last 40 years as unencumbered monetary policy availed cheap capital for the investment class to maximize profits, lower costs of production and spur innovation and competition, creating an extended period of price disinflation and declining interest rates. Looking back to 1900, however, bonds have a long-term Sharpe Ratio lower than that of equities, which isn’t surprising given equities are more correlated to human capital, nominal growth and consumption.
As bonds depart from their exceptionally high Sharpe Ratios of the last four decades, we believe investors should acknowledge the structural factors driving the trend component of inflation as they may contribute to a slightly stickier trend and more spikes in inflation going forward.
Labor Supply Decline
The dependency ratio, which is ratio of the number of older dependents to the working-age population, has been increasing sharply as the Baby Boom generation began retiring in 2011. The more workers the economy has relative to dependents, the more disinflationary pricing will be because one doesn’t employ someone else unless they expect the value of their output to be greater than the wage they are paid. Thus, an increase in the proportion of workers is generally disinflationary, whereas an increase in dependents is inflationary as they consume but do not produce, forcing wage increases across the labor pool. This relationship is expected to continue as more of the Baby Boom generation retires and lives longer than previous generations.
Inequality and Populist Political Cycles
After having left his job as Federal Reserve Chairman in 1978, Arthur Burns gave a telling speech at the IMF in Belgrade entitled The Anguish of Central Banking. He states:
“My conclusion that it is illusory to expect central banks to put an end to the inflation that now afflicts the industrial democracies does not mean that central banks are incapable of stabilizing actions. It simply means that their practical capacity for curbing an inflation that is continually driven by political forces is very limited.”
Burns is referring in part to President Lyndon B. Johnson’s “Great Society”, an ambitious series of policy initiatives and programs with the goals of ending poverty, reducing crime and abolishing inequality. Until recently, it was the largest social reform plan in history. The legislation’s fiscal spend combined with that of the Vietnam War laid the groundwork for the initial surge in the Great Inflation.
Today’s income inequality and record lows in trust of the country’s institutions echoes society in the 1960s. The combination of Biden’s three plans and COVID-19 relief amounts to the largest fiscal stimulus in history as measured as a percentage of GDP. As we approach mid-term elections in November, the political climate may demand populist agendas from both sides of the aisle, which could reinforce its impact on inflation.
A Capital Cycle in Commodities
At the core of the last two years’ 30% annualized rally in commodities is a structural underinvestment in commodities supply amid the previously mentioned policy-induced rise in demand. The influence of environmental, social and governance (ESG) investment mandates and superior returns on capital from disruptive growth stocks led investors to significantly redirect capital toward the “new economy” and away from the “old economy”.
An illustration of this was in 2021 when the sum of the market capitalization of energy companies in the S&P 500 was temporarily eclipsed by Tesla. The overextension, misdirection and redirection of investment dollars seeking higher returns on capital among industries is called a capital cycle, and it can represent significant investment opportunities.
Unfortunately, the level of underinvestment in natural resources has left the world with inadequate supply to weather large shocks, exactly at the time when a significant amount of additional fossil fuels will be required to achieve the renewable energy agendas being set by governments globally. While energy prices will be volatile and influence inflation both up and down as the market anticipates changing energy demand going forward, the supply problem still exists and may reinforce a higher trend in inflation.
Sharpening Portfolio Construction
Given the bond market’s reaction to persistent inflation globally and the structural drivers that may keep a floor on the trend component of inflation, investors may seek to reexamine the assumptions of the role of nominal bonds in the portfolio and explore more inflation-resistant sources of income to offset portfolio inflation sensitivity.
Important Disclosures & Definitions
Bloomberg Global Aggregate Bond Index: measures the performance of the global investment grade, fixed-rate bond markets, including government, government-related and corporate bonds, as well as asset-backed, mortgage-backed and commercial mortgage-backed securities from both developed and emerging markets issuers. One may not invest directly in an index.
Consumer Price Index (CPI): a measure of the average change over time in the prices paid by urban consumers for a representative basket of consumer goods and services. One may not invest directly in an index.
Core Inflation: a measure of the change in the costs of goods and services, excluding the costs of energy and food sectors.
Environmental, Social and Governance (ESG) Investment: a set of standards for a company’s behavior used by socially conscious investors to screen potential investments. Environmental criteria consider how a company safeguards the environment, social criteria examine how it manages relationships with employees, suppliers, customers and the communities where it operates, while governance deals with a company’s leadership, executive pay, audits, internal controls and shareholder rights.
Headline Inflation: the raw inflation figure reported through the Consumer Price Index (CPI) that is released monthly by the Bureau of Labor Statistics which is derived from the cost to purchase a fixed basket of goods.
S&P 500 Index: widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization. One may not invest directly in an index.
Secular: refers to market or trending activities that unfold over long time horizons, or that aren't influenced by short-term factors and are likely to continue moving in the same general direction for the foreseeable future.
Sharpe Ratio: a measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment.
Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.
AAI000188 11/30/2023
