June 10, 2021
The concept that prices are rising and inflation is here is pretty widely agreed upon, and we would say is a consensus idea. Recently, I had my own encounter with inflation. On my way home earlier this week, my car dinged to tell me I was running low on gas. I thought, “no problem, I will get gas at Kroger when I pick up the items on the list my wife texted me.” When I pulled up, there were lines of cars around the gas station with lines at each pump 2-3 cars deep. I thought, “I’ll just get the groceries and get gas when I come out.” Big mistake – in the 20 minutes it took me to get the groceries, the Kroger gas station had changed the signs (and the pumps) and the price for regular unleaded went from $2.85 to $3.15. If an over 10% jump in prices in 20 minutes isn’t inflation, I don’t know what is.
Inflation is consensus, but whether it sticks around is not….
Late last week, TJG Portfolio Manager Alex Durbin and I had a chance to attend the Memorial PGA Golf Tournament in Dublin. It was a great chance to enjoy a beautiful day, have golf going on in the background while we talked investments, and connect with clients and friends. Alex and I spent some time by the 14th hole talking to a friend who had come down from Detroit to watch the tournament who works for one of the largest bond fund managers in the world. A number of TJG clients, particularly in retirement plans, own one of the bond funds managed by his company, so it was a good chance to get an update. Here is a paraphrased synopsis of our conversation:
Travis/Alex: “So, what’s the latest on the fund?”
Fund Company Friend: “It was a rough start to the year as interest rates went up, but the last few months have been terrific as rates have stabilized.”
Travis/Alex: “We’ve noticed, and that’s great to see. Has the rate position changed?
Fund Company Friend: “We think interest rates are going down later this year and we’ve actually increased our duration (interest rate sensitivity). We believe the 10-year Treasury ends this year between 1.0% and 1.2% (Editor’s note: the 10-year rate is currently 1.5% as of 6/9/2021, down from 1.75% in March)
Travis/Alex: Wow, that’s not what most people are thinking! What about inflation? With inflation heating up, most people expect interest rates to go up!
Fund Company Friend: “We believe when supply chain issues get worked out, inflation is going to settle down and rates will stay low. Inflation is increasing today because we’ve had this surge in demand and production is slower to come online so we’re seeing shortages and delays. As production catches up, inflation should moderate. When that happens, we expect rates to come down. Rates actually peaked in March of this year and have generally been trending down since then. The rate behavior isn’t consistent with sticky inflation.
Travis/Alex: Fascinating…if that’s the way things play out, it has some interesting implications for asset classes later this year….
We’re absolutely concerned about inflation and inflation is clearly going on all around us. We would say most people expect inflation to accelerate and interest rates to rise, but here is one of largest bond managers in the world positioning for the opposite to happen.
What would be some of the portfolio implications if they are right – if rates go down between now and the end of the year? Here are three key thoughts:
- Bonds likely outperform cash by a meaningful amount. Interest rates going down implies prices for high quality bonds would tend to rise. If the rate forecast would come true, basic math would imply a core intermediate bond may experience 2% to 4% in price gains between now and year end on top of the interest the bonds would pay.
- Inflation hedges may not continue their leadership. In general, when we look across client portfolios this year, the parts of the portfolio most sensitive to inflation (i.e. real assets such as commodities, real estate, and infrastructure) have been among the best performers. If inflation really does slow down, those areas may not be leadership in the back half of the year. We are fans of real assets and have an “overweight” stance in portfolios, but the variety of outcomes which may play out has us cautious on getting too overweight.
- Stocks can continue to perform well, especially growth stocks. Low interest rates and positive economic growth is an ideal environment for stocks and is supportive of higher stock valuations. Mathematically, low interest rates are especially positive for growth stocks as the “discounted present value of future earnings” for a growth company is higher when interest rates are low. Growth stocks outperformed in 2020, but have lagged the broader market so far in 2021. If interest rates decline, it could spark a resurgence in growth leadership within the stock market.
Successful investing is a continuous learning process. We believe engaging in conversations which challenge the consensus makes for better investing, and most importantly can lead to better results for the objective-based portfolios we have the privilege to manage on behalf of our clients.
Written by Travis Upton, Partner, CEO and Chief Investment Officer