We view inflation risks as underappreciated for 2020 – and beyond. Our base case is for modestly higher U.S. inflation this year, with a risk of upside surprises. Drivers include rising wages and energy price volatility in the short term, and deglobalization over time. We like Treasury Inflation-Protected Securities (TIPS) on a tactical basis as their valuations look attractive relative to our inflation outlook. On a strategic basis, TIPS can also serve as a source of portfolio resilience against both inflation and growth shocks.
Government bonds play an important role cushioning multi-asset portfolios against equity selloffs. Our analysis showed both nominal U.S. Treasuries and their inflation-linked peers have generated positive returns when growth shocks triggered equity selloffs – albeit with nominal bonds beating TIPS. Why? Declines in both expected inflation and real rates help drive up nominal bond returns, while TIPS only benefit from falling real rates under such a scenario. TIPS’ relatively limited liquidity may also mute their rally during any market stress. But TIPS have outperformed in inflation shocks. See the chart above. The “double resilience” property of TIPS – their ability to cushion against adverse growth and inflation surprises – is why we see a case for substituting some nominal government bond exposures for TIPS in strategic allocations.
The dovish pivot by key central banks in 2019 and easing of financial conditions have played an important role in setting up global growth for a modest pickup this year – our base case for 2020. We already see inflation firming on the back of rising capacity utilization and stronger wage growth. The potential for upside inflation surprises in the U.S. has led us to favor TIPS on a 6-12 month tactical horizon. Our BlackRock Inflation GPS points to core (excluding food and energy) consumer price inflation rising to around 2.4% in six months’ time, slightly above consensus expectations and the November reading of 2.3%. Yet market-based inflation expectations remain depressed. The pricing of 10-year TIPS implies an expected average annual inflation rate of just 1.8% over the next decade – a persistent undershoot of the Federal Reserve’s inflation target. Meanwhile the U.S. labor market boasts the lowest unemployment level in nearly half a century and wage gains are near their strongest in a decade. We believe the Fed will likely allow temporary inflation overshoots and see a high bar for it to raise rates. This all points to upside risks to inflation – and an attractive entry point for TIPS given depressed market prices.
Over time we also see the risk of a regime shift that raises inflationary pressures while dragging on growth. Supply shocks stemming from structural trends such as deglobalization are one potential trigger. Geopolitical and trade frictions could disrupt global supply chains. This would reduce productivity and reinforce a slowdown in potential growth, while pushing up input costs. When such supply shocks dominate, stock and bond prices often have moved in the same direction, our analysis of the U.S. business cycle since 1965 shows. This would be a big shift from the environment since the late 1990s, when the negative correlation between stock and bond returns made bonds effective portfolio diversifiers. TIPS could provide some portfolio resilience under such a scenario, we believe. The market price dynamics described earlier make it a good time to start building a strategic TIPS position, in our view, even as we expect trade tensions likely to move sideways in 2020.
We like TIPS on a tactical basis but would avoid inflation-linked bonds in the euro area or Japan as inflation expectations still appear depressed but actual inflation rates are stubbornly below central banks’ targets. On a strategic basis a blend of nominal and inflation-linked U.S. government bonds could create resilience to a variety of adverse conditions, including both growth and inflation shocks. We also tilt toward U.S. Treasuries for portfolio ballast, as European and Japanese government bond yields appear to near lower bounds, diminishing their ability to cushion portfolios.