“We believe inflation risks are underappreciated and underpriced. Now may be an opportune time for forward-thinking investors to add inflation risk management to their portfolios,” says Stewart Taylor, Diversified Fixed Income Portfolio Manager at Eaton Vance on the company's blog.
According to Taylor, it’s easy to understand the lack of investor demand for this asset class. The CITI Inflation Surprise Index has been negative 52 of the last 53 months. With the exception of the financial crisis, year-over-year (YOY) headline CPI has been lower than at any point since the late 1960s.
"What many investors don’t appreciate is how persistent weakness in energy and food prices has hidden the underlying growth in services inflation. While energy and food represent only 21% of the CPI, they explain about 80% of its change," he says while highlighting:
- Spot WTI crude is down 55% from June 2014, while the S&P Goldman Sachs Food Index is down roughly 50% from its 2011 high.
- Over this same period, the YOY run rate for services inflation has averaged 2.5% and has climbed above 3% over the past few months.
Because of this, Eaton Vance believes that the bear market in food is over and that the energy bear market is either over or in its very late stages. "Strength in energy and food should quickly translate to higher goods CPI, which, in turn, should help boost the already elevated services CPI. There is also evidence of increasing wage pressures. The 3.4% YOY growth in the Atlanta Fed Wage Growth Tracker in April is the strongest growth since February 2009. Historically, wage pressures have been associated with periods of higher inflation" Taylor writes.
The April CPI highlighted the changing inflation dynamic: The month-over-month change in headline CPI (0.4%) was the biggest monthly gain since February 2013. Also, at 2.1%, YOY Core CPI is now above the Fed’s 2% target; at 1.6%, YOY Core Personal Consumption Expenditures (PCE) (the Fed’s desired metric) is approaching its 2% target.
The trend in year-over-year Core CPI bottomed in early 2015 and has since been moving higher. Several alternate CPI measures that attempt to remove the most volatile index components to better ascertain the underlying trend also confirm this.
Taylor and his team think that investors are beginning to realize that the bear markets in energy and food are near an end. After roughly a year of outflows, net flows into TIPS funds and ETFs have turned positive over the past two months (ended April 2016), while break-even inflation rates on 5-year TIPS have begun to price in higher expected inflation. "We think these trends are still in their early innings." And that "inflation assets are inexpensive relative to growing inflation risks."