Thursday, May 28, 2015

How to Invest in A Rising Rate Environment?

(Updated on 12/27/2021)
To see broad and persistent price inflation in an economy, we generally need two things. The first is a persistent rise in broad money supply, and the second is a physical constraint on our ability to produce more commodities, goods, or services cheaply.

― Lyn Alden 

Declines in the working population relative to the nonworking population is an inflationary force.

― Jesse Felder

After all, populism, protectionism and deficit spending are all inflationary.
― Deutsche Bank's Aleksandar Kocic
Inflation Awakening (July 2018)
―Pimco
In truth, inflation is all about the destruction of confidence in a fiat currency’s purchasing power. And there is no better way to do that than for the government to massively increase the supply of money and place it directly into the hands of its citizenry. In other words, helicopter money and Modern Monetary Theory (MMT) were deployed—and in a big way. The result was the largest increase of inflation in 40 years.

All 0f the above predications have come true, inflation was reported hitting 9.1% in June on 07/13/2022:[75]
Inflation hit a fresh 40-year record in June, with consumer prices increasing 9.1% over the last 12 months, the Labor Department said Wednesday. It's the fastest increase in prices since November 1981, and above what economists had expected.

If inflation comes, interest rates DO rise.  In this article, we will discuss how to invest in a rising rate environment if inflation is expected among market participants.

What's Inflation?


When we talk about inflation/deflation, it is important to know whether we’re talking about monetary inflation (i.e., generally Austrian's view) or price inflation (i.e., generally Keynesian' view).[36] As we have seen recently, a rising money supply is not necessarily accompanied by rising prices (although there is a certain long-term rhythm to the two different measures).

Broad money supply and price inflation are rather correlated.  The most precise way to phrase it is that:[74] 
Rapid money supply growth is necessary but not sufficient to cause widespread price inflation.

In other words, price inflation always tends to happen when money supply grows very quickly, but a rapid growth in money supply does not always lead to substantial price inflation.

POV—Economists vs Regular People


Jason Furman, Obama's former CEA chief, noted that economists "tend to be less bothered" by inflation than regular people.[73] 
At first this seems counterintuitive. After all, economists seem to be talking about inflation all the time. But on the other hand, given the impact of food and gasoline prices, and other highly salient items, on economic sentiment, it's clear that inflation weighs heavily in the minds of the general public.

The one area aspect of inflation that economists do tend to worry quite a lot about is inflation expectations. The fear is not so much that gasoline prices or car prices or meat prices will run hot for a couple years. Their fear is that the public psychology around inflation will change. That we'll see panic buying. That we'll see a price spiral, and that this will have destabilizing effects on general welfare. In this view, Volcker's triumph wasn't that he defeated inflation per se, but that he defeated an inflationary mindset. And so economists are mostly concerned with securing and consolidating that victory.

Figure 1 shows that in the long run, interest rates tend to remain above price inflation (investors need to earn a real rate of return), but it also shows that the wedge between interest rates and price inflation has narrowed on a secular basis. We would argue that this is because over time, the Fed-to-market reaction function has become both more efficient and more credible; it takes a lower interest rate premium today than in the past to hold down inflation expectations.

Inflation and Interest Rate


Interest rates DO rise as a result of price inflation.[15] Over the long term, price inflation (here we use Core CPI; Note that rise in inflation could be made up of rising oil prices which will affect both import and export prices. However, oil is volatile, and the rate of core inflation―ex. food and energy―is the true rate of inflation that the bond market reacts to and also the one will influence the Fed policy) is by far the best indicator of interest rate trends (Figure 1).[1] A combination of factors has led to a secular lower profile for inflation now than in the 1970s and 80s. These factors include:
  • A better supply-demand balance in energy markets
  • The benefits of increasing globalization 
    • At the macro level, globalization has made price inflation slow to emerge, as multinational companies can shift production around the world in response to cost pressure.[17] 
  • The evolution of Fed policies, which now include more effective tools and more timely transmission to the real economy.
These factors have given central banks more room in increasing money supply without facing the price inflation consequences for years. Hence, central banks around the world have become more active in response to economic fluctuations. The consequence is a rising ratio of money supply or credit to GDP. By definition, this means a bigger and bigger financial system, which needs more and more income to survive.

Consumer Price Index


The official measure of price inflation is the Consumer Price Index.  The composition of the CPI (consumer price index) is as follows:

Source: Doug Short

However, the definition of CPI was changed substantially to include a different basket of goods, and there was a rapid rise in cheap processed foods that could more easily be mass-produced, at the cost of being less healthy. In addition, money supply could go up a lot without necessarily causing broad price inflation as measured by CPI.  In summary, as Lyn Alden pointed out in her article:[74] 
Broad money supply and price inflation are quite correlated when there is a period of constrained resources, and can become decoupled when resources are unusually abundant for unique circumstances involving some sort of new area of resources or labor rapidly opening up.

Inflation Drivers


What drives price inflation?  There are mainly two drivers:
  1. Wage-price spirals
    • Wage-price spirals refer to the vicious cycle that occurs when rising wages lead producers to raise prices, which in turn, leads workers to demand higher wages, further driving prices higher.
  2. Credit growth and monetary policy
    • Price inflation is always and everywhere a monetary phenomenon. 
    • Easy credit and loose monetary policy have the potential to create significant inflationary pressure as increasing amounts of capital bid up limited resources.
Recession or Boom? Exposing Hidden Crises in the Mark (YouTube link)

Signs of Inflation[2]

Due to the lagging nature of the CPI and PCE[49,69] reports, they often don’t present the best forward-looking measure of inflation. Like the GDP, they are much better at telling us what has happened rather than what will happen.

Bond yields are very sensitive to inflationary expectations.[65] There are two places we can look for real-time market based inflation expectations are:[48]
Based on the data, global investors in aggregate are positioning themselves for roughly 2% inflation in 2021. 

Good Inflation vs Bad Inflation


Inflation can be classified into good inflation vs bad inflation:[44]

"Good" inflation is wages rising faster than prices. When wages rise faster than consumer prices, households have more money to spend on consumption, and it's progressively easier for them to pay down debt and support additional borrowing.

In Japan, where the central bank and government have struggled for years to generate price inflation as the means to "re-start growth," wages have fallen by 9% in real terms since 1997.

"Bad" inflation is prices rising while wages stagnate. In "bad" inflation, prices keep rising as central bank money-printing devalues the currency, but wages don't rise along with prices. As a result, wages decline in real terms, i.e. purchasing power.



How to Invest in A Rising Rate Environment?


If you believe inflation is happening, cash is your worst enemy, and bonds can appear less favorable as rising interest rates may decrease the value of outstanding bonds. Instead, you would prefer items like stocks, gold, and real assets, which are historically good inflation hedges.[48]

Strategies employ real assets aim to have either an explicit or implicit return correlation to inflation. Real assets include inflation-linked bonds,[58] commodities[64] and real estate investment trusts (REITs)[70] or other inflation-fighting assets. This can potentially enhance portfolio diversification, mitigate inflation risk and provide more stable real (after-inflation) returns.

In the chart below, Citi bank also shows the 5 year correlations of weekly returns (sector relative returns vs 10 year UST total return).  You may also base your investment on the appropriate sectors in a rising interest rate (or higher bond yields) environment.




In another chart below (click to enlarge), Janus' asset allocation model shows the firm's sector preferences in a rising rate environment.[53]

Fiscal stimulus, in Janus' view, would have a more direct impact on the real economy. The firm feels the end result would be an increase in demand-pull inflation. This demand-pull driver combined with the cost-push inflation driven by tighter labor supply and the recent reset of commodities prices to a higher range creates an environment where inflation happens.

In Janus' view, this demand-pull inflation should benefit consumer discretionary names as workers are incentivized to spend. Materials and energy firms should also effectively manage cost-push inflation, especially following the recent uptick in commodity prices.


Recession vs Inflation


Video 1.  Will The Coming Recession STOP Inflation? (YouTube link)

Video 2.  I-Bonds For Inflation Protection (YouTube link)

References

  1. Is Inflation Next?
  2. Inflation is coming?
  3. Are You Ready for Rising Rates?
  4. Rising Rate--What You Need to Know?
  5. Don’t dump your bonds when interest rates rise
  6. Personal Income and Outlays
  7. Inflation Is Coming, What to Do—Now
  8. Why The Fed's Dual Mandate Is Doomed (In 2 Simple Charts)
  9. Assuage Your Fears of Rising Rates with Global Diversification (Pimco)
  10. Moving Forward With the Normalization of Yields (Pimco)
  11. A Classic Barometer 
  12. U.S. Inflation Edges Up In March But Inflation Expectations Remain Moderate
  13. Market Beginning to Shift Inflation Expectations
  14. Tight Job Market in U.S. Cities Prompts Higher Pay
  15. What’s the Relationship Between Inflation and Interest Rates?
  16. Daily State Of The Markets: Bears Got It Wrong Again (On Bonds)
  17. Slow Motion Bust - The Long Goodbye - One-Sided Incentives
  18. What To Do About Inflation Risk
  19. Get Ready For Higher Food Costs
  20. Wage Inflation?
  21. A Leading Indicator Of The Coming Inflation?
    • Allan Meltzer warns that increases in food prices have been a leading indicator of inflation in past cycles.
  22. Producer Prices Jump, Hint of Rising Inflation
  23. Peter Warburton: The debasement of world currency: It is inflation, but not as we know it (Peter Warburton's classic essay from 2001)
  24. Stagflation Is Now On The Table
    • The reason why the interest rates are so low?  May be that America and the world at large is growing older, retiring, and are choosing to keep their money in government bonds, and other "safe" investments, and more in cash than ever before
    • If so, low interest rates may not move higher as inflation goes higher as they normally have. They may continue to respond instead to a slowing and unpredictable economy.
  25. StreetSmart Post
    •  The price of oil is usually a pretty good indicator of overall inflation. 
  26. A Look at the Coming 30-Year Inflation Cycle
    • War is always inflationary for commodity prices and would only serve to heat up the economy faster than the new 30-year inflationary cycle would do on its own.
  27. The Seeds of U.S. Inflation Have Sprouted and Could Be in Full Flower in 2016 
  28. BLACKROCK: 2 Big Market Stories Investors Should Focus On Right Now
    • Such segments include both small caps and certain defensive income plays, like utilities — both of which have historically proved more vulnerable to contracting valuations as real rates rise.
  29. MIT vs. ShadowStats – Who’s Right on Inflation?
  30. The Prices We Pay: Part 2
    • People’s short-term inflation expectations are very sensitive to movements in oil prices
  31. Sisyphean Fed Struggle to Create Inflation; Faber on Gross' Deflation Theory, Japan's Bond Ponzi Scheme, and Gold
  32. After the Bank of Japan, the long march of the RMB is over
  33. Labor Market Strength Increases Odds of Rate Hike
  34. How the Markets Tempt Us Into Making Mistakes
  35. How to Create a Bond Ladder Using ETFs
  36. Thoughts from the Frontline - The Last Argument of Central Banks‏ 
  37. Bond Market Outlook: Low Rates Into 2015?
  38. GOLDMAN: The Stock Market In 2015 Will Be
    • Goldman Sachs forecasts 2018 neutral fed funds rate of 3.9%; others expect ~2%
  39. Stock Trading Data Service Providers 
  40. Miller's Money Weekly (December 4, 2014)
  41. We Were Crazy Hippie Bastards
  42. This Is What The Next Financial Crisis Might Look Like
  43. The Fed's Policy Trajectory Is Tied To Global Recovery
  44. Central Banks Have Failed Because They Can't Push Wages Higher
  45. What Lies Behind The Plunge Of The Ruble? (good)
  46. Interest Rate Trends
  47. U.S. Stocks Living On Borrowed Time As 2015 Begins
    • Statistically, the rate of increase in current government expenditures at 1.2% per year (i.e., spending growth) from 2010-2014 is historically in the deflationary zone.
  48. Is Inflation on Our Doorstep?
  49. PCE
    • This number – the PCE annualized inflation rate – is released near the 20th of every month
  50. What is Inflation? A Mauldin Economics Guide to Inflation, Deflation, and Everything In-Between
    • Cost-push inflation: arises when wages, taxes, raw materials, or import costs increase 
    • Demand-pull inflation: occurs when too much money chases too few goods
  51. There are 2 good options to protect your investments from inflation
  52. Bank on this Play for Rising Rates
    • Big banks vs regional banks (KRE)
  53. Is Inflation Bubbling Below The Surface?
  54. Prediction About Future Of Inflation
  55. 2017 Global Investment Outlook (BlackRock)
    • Increases in inflation expectations priced into the bond market have been one of the main results of this increase of expectations of future inflation.
    • Rising rate will cause pain for holders of long-duration bonds. However, in this environment dividend growers – companies with sustainable free cash flow and the ability to raise payouts over time without harming their balance sheets – look attractive.
  56. The Billion Prices Project
  57. LIBOR At 1% For First Time In 7 Years - A Significant Level For Leveraged Loans
    • Due to the floating-rate characteristics discussed int this article, leveraged loans tend to perform well in environments of rising rates (or expected rising rates). 
  58. Primer: Understanding Inflation-Linked Bonds (good)
  59. Should We Be Worried About Inflation?
    • A correlation study is a reliable tool to determine asset classes that are most effective in terms of hedging against unexpected inflation.
    • The most effective asset classes to hedge against inflation are commodities, certain real assets such as oil and private real estate, and TIPS.
  60. Nominal interest rate vs real interest rate
    • nominal interest rate = real rate + premium
      • premium could be
        • liquidity premium
        • political risk premium
        • currency premium 
    • Investors in fixed income products typically get the nominal returns
  61. 5-Year Breakeven Inflation Rate 
    • The latest value implies what market participants expect inflation to be in the next 5 years, on average
  62. 5-Year, 5-Year Forward Inflation Expectation Rate
    • This series is a measure of expected inflation (on average) over the five-year period that begins five years from today
  63. Corrective Forces Persist
    • A market-based measure, the 10-year breakeven (conventional yield minus the 10-year TIPS) has been stable since early November around 2.0%.  
  64. The growing case for commodities (etf Investment Insights)
  65. Hoisington Quarterly Review and Outlook—4Q2016
  66. Update On The Food Inflation Cycle Theme: Next Leg Is Coming To Cereals
    • In past inflationary cycles, oils had led cereals by 6 months.
    • It's understandable why most equity investors domestically focus on cereals when it comes to soft commodity inflation. 
    • The majority of investment options are driven by the top three crops: corn, soybean, wheat, and arguably one could simplify it down to just following the price of corn as a tell.
    • The FAO Food Price Index (The Food And Agriculture Administration of The United Nations ), as the best tracking method for determining when a food inflationary cycle has started.
  67. At Least One Type of Equities Is Still Undervalued: REITs
    • REITs own commercial properties that collect long-term streams of rental payments, and their prices generally rise with inflation. 
  68. The Beginning Of Your Investing Career
    • Commodity investing is fraught with all kinds of complex risks, but investing in companies that produce commodities is relatively straightforward.
  69. The other inflation measurement
  70. Inflation Awakening (Pimco)
  71. 18 Month Average Retail Price Chart
  72. Inflation Will Come Back With a Vengeance
  73. Transcript: Jason Furman on Red-Hot Inflation and What to Do About It
  74. What Price Signals Are Telling Us
  75. Inflation hit 9.1% in June, highest rate in more than 40 years
  76. Two kinds of money printing (pdf)
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