Global Perspectives Podcast – Come on down: is inflation priced right?

Adam Hetts: Welcome to Global Perspectives, where we feature candid conversations with Janus Henderson’s thought leaders. I'm your host, Adam Hetts, Global Head of Portfolio Construction and Strategy. And today I'm very much looking forward to our inflation conversation with Jim Cielinski. Jim is our Global Head of Fixed Income. He oversees all of our fixed income products and teams and leads corporate credit as well. Prior to joining Janus Henderson, Jim was the Global Head of Fixed Income for Columbia Threadneedle. And prior to that, he was at Goldman Sachs Asset Management as a Managing Director and Head of Credit. So Jim, thanks for being on.

Jim Cielinski: Thank you, Adam. It's great to be here.

Hetts: Inflation seems top of mind for just about everyone so it's great timing to have you here. And while you and I were talking about this episode coming up, we kept getting back to this concept that “inflation protection” can actually be very risky on its own and that maybe the biggest portfolio risk for inflation might simply be an investor overreacting and allocating to a new set of risks they never had before. And we're going to unpack those asset allocation risks in a bit. But first Jim, as a global bond investor, can you go ahead and set the table with your outlook on inflation in general right now?

Cielinski: Sure, Adam. And I think that's a great point to make. It's all anyone seems to be talking about, inflation and where is it going and how will the Fed respond? And I think it's always good to remind yourself that when you're talking about it so is everyone else. You know, there's a good chance that a lot of that is priced in or expected by the markets and you need to take that into context. I think when we look at inflation, it really first of all has accelerated and I think for many, they're looking at us and saying, “Well of course, inflation is going up, and we see it all over the place.” But it's actually quite a bit more complicated than that. And I think my view and for many in the team here, is we do think a lot of this is transitory. I know that that's what the Federal Reserve feels, but there are real reasons for thinking that. And this is one of the most unusual periods both for growth but also for inflation that I think we've ever seen. And people I think have discussed the base effects, the reopening premium and then what is really sustainable.

My view is that inflation will be higher than it was before the pandemic, but very modestly so. And what we're seeing right now is really a well above-trend path in inflation for a few idiosyncratic reasons. And I think perhaps nowhere is that best exemplified for example, in let's say we just followed the price of oil over the last say 15 or 18 months. And it kind of tells you a lot about the underlying story. If you look at the generic Brent oil contract pre-pandemic, it was about $60 a barrel and then it plummeted in the pandemic. As the economy just simply shut down, it was kind of like a light switch being turned off. Oil fell below $20 a barrel and then earlier this year, it rose back up to $60.

And so think about what that means. Today, it's at $70 by the way, and so the path from $60 to below $20 was hugely deflationary. Now, the path from $20 back up to $60… and that's where it was pre-pandemic. So in fact, price pressures in an overall sense really didn't move, but the distortion in the numbers was staggering. So these are the base effects that people are talking about.

But oil has now moved let's say to $70 and so there's been even more price increase in this commodity, 10%, 15%. And some of this is due to the re-opening premium and that is if we flip the light switch back on, you know, suddenly you find that shipping containers are in the wrong place. People need to start up factories and they don't have enough oil in storage. Or there’s a chip shortage because everyone now wants to make new cars. And as that happens, the supply chains are a bit broken, price pressures increase further. But that's also somewhat transitory and as all that kind of corrects and you get the shipping containers back in the right places, that reopening premium will also fade.

So there is a third component, however, of say the oil price increase. I'm using oil as an example because I think we could apply it to many things in the economy. It's just a great and real-life example for people to understand the dynamics at work. So the third component of that price increase is probably just due to the fact that growth is stronger than expected. And I think that's the part that is not transitory. Those first two components, the base effects and this kind of reopening premium are actually quite transitory. But that's probably 85%, 90% of this inflation trade that we're talking about.

And so when you're thinking about where inflation goes from here, I think it's wise to mostly disaggregate inflation into these three components. Focus on what's going to be permanent and that is the piece that will be due to strong growth. And growth is stronger than expected. The reopening strength and the rollout of vaccines has ensured that growth is really robust globally. And some of this may be longer lasting. In a year, if we can keep growing, it will close the output gap. And if you see that and you see higher wages, that's what will produce a more permanent inflationary backdrop.

So I think it's important when you see huge distortions like we've seen in the pandemic, to try to break down what's really happening. And as I do that, a huge portion of the inflation that we've seen and keep in mind that CPI inflation over the last 12 months is 5%. And you know, that's way higher than the 2% target from the Fed. It probably slows to maybe 4% on the full year, but that's still twice what the Fed’s target is. And so I think we should acknowledge that inflation has been real but the reason you know many of us including me, aren't so concerned is because I do see a big part of this as being somewhat temporary in nature. So watch the signpost for global growth. That’s what should make us worry longer term.

So I think inflation after this spike will return to more normal levels, but still higher than the inflation was before the pandemic.

Hetts: For all the scary headlines out there, I think this is a great start trying to disentangle the signal from the noise. And as far as the noise you mentioned, you know, CPI is up 5%. But like you say, there have been huge movements in commodity prices. Oil being one example, are people too caught up by these one-off distortions?

Cielinski: The dispersion was massive. I think commodities really took it on the chin and that's what's now bouncing back. And so you saw the deflationary shock, now you're seeing the reopening inflationary shock. And I think to look at either one of those as a permanent number is a mistake. The fact that we focus so much on year-on-year comparisons, I think these are the kinds of periods where you should not look at year on year. Try to get a good sense of the run rate. And the run rate right now is a little bit hotter than I think we've seen, but there is a reason the Fed isn't overly concerned. It’s not so hot that they think it is permanent and a little bit of inflation in a high debt world is actually not a bad thing.

Hetts: And we'll get into that a little bit, more in a bit about how inflation can be good and healthy and where the optimism is. So I think on the macro front, if that 5% increase is a bit of the transitory noise, then the signal you're looking at is what you mentioned about the more longer-term increase in growth and potentially closing the output gap, looking for higher wages. So can you give us some more examples of, as a bond investor specifically, what you'd be watching most closely as far as some of those other signals? And then also from a global perspective, just how you're thinking about inflation, not universally, but different across regions, maybe just to start with U.S. versus Europe?

Cielinski: Yes, great questions. I think to really see a permanent increase in inflation and the kind that would worry policymakers, I think two things need to happen. One, you need to close the output gap and that is probably a more global phenomenon. There's still a lot of excess capacity. And until you close that, I think the persistent price pressure is difficult to see. And then the other key thing is wages and wage inflation. I think real shortages of workers that leads to a real shift in power towards labour I think is the type of element that creates kind of a self-reinforcing kind of upward spiral.

Now, I think this is where you've seen concerns begin to mount and I would argue this is the right place to focus. And if there is a concern, it's whether this is part of the reopening and just people trying to shuffle around jobs and get people in the right places. There's a lot of that going on. Or whether this is truly a permanent shift. I think as you see the fiscal stimulus start to fade a little bit and as the global effects, remember that the secular backdrop for inflation, whether it's productivity, the increase in technology, the debt overhang, demographics, all these things are still there. All the super powerful elements behind disinflation that have been around for the last two or three decades are still there. And I think those are the reasons why you still might think that the wage pressures you know again, are probably a little bit permanent, but probably more temporary.

I think wages and wage inflation coupled with high growth that would close the output gap is what I would focus on. So I think those are the keys. Ignore the volatility kind of near-term.

You mentioned the global backdrop which I think is really quite important because regions like Europe or Japan are still very much caught in the disinflationary cycle. You’re seeing growth rebound in those regions because this is a true global rebound because the light switch kind of was switched off for the globe, not just for each country. But in Europe for example, you have more of those structural issues I just mentioned. You’ve had less fiscal stimulus. And so those really tight markets that you're seeing produce some of those pressures really aren't being seen as much in Japan or Europe. And inflation ultimately, is a global phenomenon. We should not lose sight of that. And the fact that the U.S. and the UK, in some other markets maybe like Canada that eased aggressively, are kind of leading the charge higher.

I think we should remember that that is only part of the globe. The disinflationary backdrop across the rest of the globe should keep a lid I think on global inflation rates and so that’s why the focus is on the U.S. But again, if fiscal stimulus fades as it will and we get through some of these near-term kind of bottlenecks you know, I would see the same disinflationary pressures begin to bubble up a little bit and keep a lid on CPI and PPI as we move forward.

Hetts: I think a really important message for the listeners and that answer is this, super position of inflation in the sense that it's regional, but it's also global and that we're going to see wages going up but we've also got two or three decades of deflationary pressures. So I think that knee jerk reaction of some to compare it to the 1970s and see some parallels there, then draw some extrapolations isn't going to work going forward because there's too much nuance here. And then the same goes as far as the traditional tools you can use to fight inflation in portfolios. There's no simple answer, there's no single solution at the asset class level to all of a sudden fix your portfolio as it comes to inflation.

I think that's a good transition from the macro side here to the asset allocation side. And I can start by sharing a bit of what my team sees during our client portfolio consultations. And a lot of the time, the conversation centres just around TIPS, floating rate and high yield when it comes to fixed income portfolios and inflation. And think that's great. Those all have potential ways to combat inflation, but the scary thing to me is they all have plenty of unique risks of their own. And when it comes to diversifying a fixed income portfolio, I'm always cautious and scared of which new risks get introduced to that most sensitive part of an asset allocation. So I think it's most important for me and you Jim, if we focus a bit less on the benefits, which everybody else is talking about, and more on the risks specific to these inflation tools that are getting more popular. And how about we start by looking at the core sovereign part of the investor's portfolio where TIPS might be most relevant? And instead of focusing on just the benefits Jim, what are the risks you see in using TIPS?

Cielinski: Well, I think on TIPS, the clue is kind of in the name. It says inflation protected, but there's nothing about real rates protection in TIPS and if you look at the current yield for example on a five-year TIPS, it's about -1.7%. And real yields are what have remained shockingly low through the sell off. And if you decompose what a bond yield looks like and what it was looking like as we got the inflation fears, it was all about inflation premium that was being built in to bond yields.

The real rate, and if you think of a nominal rate as being real rate plus inflation premium, real rates barely moved. And they started this whole phase at really low levels. So they've remained at shockingly expensive levels and that's what you're getting if you buy TIPS. You're getting that really low real yield, which looks displaced frankly, relative to the strength of the economy. The risk in buying a TIPS today, I think would be some correction in that real yield number. And if growth continues to surprise on the upside and central banks take a less active position in the bond markets, I would think that real rates are what you should be fearing. So the inflation element is there, so you're kind of getting that premium whether you buy a nominal bond or TIPS. The real rate component though, is what looks very expensive. And by buying a TIPS, you're fully exposed to that risk. And so it may feel intuitive that you're getting protection there and you are in a way, you're just paying a lot for it.

Hetts: And then to rephrase it a bit, so TIPS are sort of in theory tethered to nominals, traditional Treasuries. And if you have a five-year TIPS with real yield of around -1.7 [percent], and then the five-year nominals yielding around 0.8%, that tethering implies that you need about a 2.5% rate of inflation to “break even,” which is what people mean when we talk about “breakevens,” with the breakeven inflation being a difference between the real yield on TIPS, and the yield on the nominal bond of the same maturity. And if inflation ends up coming lower than that, then as you own that TIPS bond compared to a nominal, then you're not going to catch up to the nominal yields. And can you play out that journey a little bit? So for somebody that's maybe swapping from a traditional U.S. aggregate or just nominal treasury investment to TIPS, what does that journey feel like? Like how long do you have to hold that TIPS security to actually get that adjustment over time? And meanwhile, what kind of interest rate risk are you taking on? Or what kind of duration are you taking on in TIPS versus nominals?

Well first of all, I mean to be assured of getting that breakeven and kind of removing the volatility, you'd have to hold it for almost the full period. I think the adjustment you would worry about right, is that inflation expectations don't move over the next year. And this is where I see the risk in TIPS is that the adjustment in real yields should growth continue to surprise on the upside. It’s probably something that we see over the next 12 months. And that's probably the horizon by which we start to view the Fed as maybe being in the wrong place or behind the curve. And so I think the jump in real yields if we get this wrong is more likely say a 12-month kind of horizon. So again, you're subject to the volatility, you know, of the underlying securities that you're owning.

Many people are buying you know, 5, 10-year securities and you know, those have durations you know, that aren't too different from you know, the actual maturity of the bond. So you know, I think you should go into those expecting that you've removed inflation volatility perhaps, but you haven't really removed any of the real rate volatility.

And then speaking of interest rate risk, I think for the investors looking to move past sovereign bond risk and take on some additional portfolio risk, floating rate is probably the next thing we should talk about. And floating rate bonds sound wonderful in the face of inflation and rising rates, but in reality Jim, what problems might you see as far as floating rates and how they react to potential inflation surprises?

Cielinski: Well, I think a few things to remember on floating rate bonds is first of all, they tend to be anchored to short term rates which are the lowest rates on the curve and the least likely to be moving up. So the advantage of a floating rate bond which is that your yield might increase, is probably one of the lower probabilities that's out there.

I think there are a few other considerations. I mean quite often, floating rates are associated with loans and other things that might have higher credit risk and so you need to be aware of the underlying credit risks that are often exhibited in that part of the market. I would add the fact that you're minimising interest rate risk when you buy a floating rate bond because it resets usually every quarter. But if it's a 5 or a 10-year security, the underlying spread risk that you might have or exposure to the credit you know, you're getting that full 5 or 10 years of spread duration. So they're not always low volatility, they are low interest rate volatility bonds.

And then finally you know, curves have steepened as markets have started to price in this ultra-easy central bank policy. And markets will basically imply then, that to be better off in a floating rate bond as opposed to a fixed rate bond, rates would actually have to move higher or move at a faster pace than what's priced in. So I think with rates having backed up a little bit you know, many of the fixed rate maturities say of say two to five years as they roll down the curve you know, as long as you don't get a surprisingly aggressive and more hawkish Federal Reserve, I think the returns could actually be higher in fixed rate bonds. And that's true, even if you see higher inflation.

So the key here is higher inflation normally works better for longer spread risk. And if you don't think that higher inflation is going to lead to aggressive Fed tightening, your returns are probably going to be better in the fixed versus the floating. So again, Adam, I think what you're saying is that a lot of these instruments that might intuitively be appealing and look like great hedges against higher inflation, you know, the pricing in the markets is something that you can't ignore. A lot of this is reflected in pricing and you just need to be aware of that. So I think floaters look okay, but again, it’s not a free lunch.

Hetts: Yes, that's really a helpful caveat that I think your knee jerk reaction might be, and not yours Jim, but investors in general, might be that if you view rates are going to go up and you're bearish on rates, well then why would you own anything fixed rate? You would just buy floating. But to your point, if the curve is that much steeper, there's more yield and more premium on the fixed side than these floating rate that are anchored to these short-term rates.

And you're mentioning some additional risk there to the credit risk and floating rate and just when you look at that, I guess I wouldn't call it an asset class, but that feature of bonds globally, what's the opportunity set in floating rate investment grade versus non- investment grade? And are you thinking that most investors are generally pushed to non-investment grade if they're seeking out floating rate?

Cielinski: Well, it's a good question because there's plenty of floating rate bonds and lots of different types. I think in corporate credit, it's the loan market that dominates although there is plenty of investment grade floaters. They tend to be financial and so I'd say it's more difficult to build a diversified portfolio. But there are other opportunities, some collateralized loan obligations, CLOs, asset backed, those tend to be you know, particularly in certain areas, almost exclusively floating rate. So I think when you go outside of corporate credit, you start to expand the list of floating rate securities quite considerably. So I think diversification is there, but I would, and I think that's a good point Adam, because if you're building a floating rate portfolio, you're trying to remove one risk. I would say don't forget that you might be increasing other risks unless you really focus on the diversity that you're building. You know, try to look at other parts of the market, whether it's asset backed and mortgages. I'd also argue that that's often where you find the most attractive [opportunities] although albeit sometimes with a little bit lower liquidity, but that's okay for many investors. But look around more broadly I think for opportunities in that floating rate segment.

Hetts: It feels a little contrarian if you're talking about the attractiveness of fixed rate versus floating rate in the face of inflation. So thinking about inflation as an investor's focus, how should that change how they view and select securities in high yield markets?

Cielinski: I think first of all, it's important to realize that inflation can be good and we are fearful of inflation right now primarily because we think it might cause policymakers to make a mistake. That's really the key risk of inflation because with this much debt outstanding, a little bit of inflation is a great thing. And if I'm a corporate borrower, I can borrow at low real rates if I can then see inflation in my revenues, that’s actually really good for de leveraging balance sheets and it's good for credit quality.

It's bad if it forces the Fed to panic or other central bankers to panic and then they'll overtighten and you know, perhaps send us into a recession or sow the seeds for the next recession. With their strong commitment not to act early and overtighten, I think the confidence that some inflation could be a good thing for areas that are more highly levered and that is high yield, right. So that's exactly what we're talking about. High yield by the way, does tend to exhibit shorter duration or less interest rate risk. You know, the empirical durations tend to be quite low and that's because credit risk dominates. And credit risk, if it's getting better in an inflationary environment, should overwhelm the interest rate risk and lead to decent returns on the asset class in general.

I think if you go through the cycle, different parts of the high yield market are probably more attractive. I think as you go through the re-opening trade, what you've seen to date is a huge rally in a lot of those commodities and energy producers. The same ones that got beaten up when we closed down were the first to kind of rally when we re-opened. And then that's also expanded into cyclicals like travel and leisure and hospitality, those industries that are going to fully benefit from the re-opening.

But I think as we move forward and we're kind of past that part of the cycle, I think looking at more consumer-oriented types of companies is probably the sweet spot. They tend to be a little bit more defensive. Savings have been built up you know, the wallets are fatter in general, you know, across the spending community. And incomes have held up and now they look like they're likely to increase. So I think the goods reopening was first, the services reopening will be second and services tend to be a little bit more linked to consumers, but also kind of business services. And so I think, beginning to shift a little bit of the focus towards those segments, as we kind of go through the reopening is probably the right way to at least protect on a risk-adjusted basis your returns in high yield.

But I think that's the sector, high yield, credit in general but probably high yield in particular. If you believe that inflation is going to go up but not be out of control and central bankers are going to be friendly and not tighten, that should be a strong performing sector. It certainly has been historically.

Hetts: So this low likelihood of policy surprises, this handoff from goods to services and a gradually rebounding. recovering economy, it feels mostly like a developed market conversation. Emerging markets debt is coming up quite a bit as an inflation diversifier, particularly local currency emerging market debt since the yields are competitive, it also has the benefit of diversifying away from an investor's developed home currency at the same time. So do you think emerging market debt is an important part of this inflation conversation?

Cielinski: I do. And I think it's becoming more important. Emerging markets (EM) first of all, do not have the same control over their policy that say, developed market countries do. And so you will likely see some emerging markets begin to tighten policy as this inflation fear is something they need to act more quickly on. You know, unlike the US that can kind of hold rates down through various forms of repression, things like that, EM will probably need to act a little bit more urgently. And that means a few things. One, they'll be out of sync with other central banks and that to me equals diversification. But I think as they do that, you'll also see the yield differentials begin to grow in favor of some EM countries.

And so I do think there is a role for EM. It comes with risk and so that to me, is something that you need to be careful around sizing and be aware of those risks. But I think for those looking for income and diversification, things that maybe aren't as perfectly synchronised as they have been over the last year-and-a-half, and the world will not be a synchronised as we exit the pandemic. I think that diversification particularly as it relates to inflation you know, is a positive. So look, I do think that EM, yes, should play a role in protecting portfolios from inflation as we move ahead.

Hetts: This has been great. We covered the macro-outlook, the superposition of inflation and its concerns, the hidden risks and TIPS, then we got into the non-investment grade side through floating rate, high yield, even emerging markets. Anything else, Jim, we haven't talked about that you wanted to cover?

Cielinski: Well, I think we've talked a lot about the components of the market and securitized ABS and CLOs I think are important components to go along with corporate credit. I think owning a mixture of different maturities and durations and diversity across different sectors, is a good way to protect yourself from what could be volatility in cash flows because this is an uneven recovery and that's not going away. That tells you, number one, try to be active, try to recognize where the crowd is and not get too caught up in just following the herd when everybody's talking about something like they're talking about inflation. Now look at what you're paying for that protection and you may choose to do something different. And so valuations are always important. And then finally, in an uneven world where there's policymaker uncertainty you know, a little bit of diversification is always a good idea. I think those would be my key points.

Hetts: That’s interesting you mentioned those points which makes me think about with all this focus we’re having on risk in this conversation, you talk about not following the crowd. And as much as inflation might be priced in, a lot of what we talked about is actually taking on additional risk compared to a sovereign bond portfolio. That's the non-investment grade side and emerging debt whereas the only core tool we talked about is TIPS, which are like you mentioned, pretty expensive and that's where a lot of the inflation is priced in. So as far as being active and maybe trying to move away from the crowd a little bit, you just mentioned offhand, securitized and/or CLOs. So just curious why you mentioned securitized and CLOs in an inflation conversation, maybe if those are becoming more popular as core diversifiers. In other words, something besides TIPS you can diversify into and still stay in the core?

Cielinski: Yes, I thought they were worth bringing up because they tend to give a little bit more income for the same credit quality, say compared to corporates. They tend to be tied to assets that in an inflationary environment, tend to be going up in value. And then the floating rate nature, if you are concerned about the interest rate volatility and a lot of those securities, not all by the way, but many of the securities in that space are floating rate. And so, I would just say they solve a lot of the issues that we've talked about. It's actually a huge market and it's becoming ever more liquid.

And so I just think as we look, it looks like we're going to be in this low-rate environment for a long time. I think as that happens, looking more broadly is a good idea. Always just looking to increase risk to get a little bit more yield because rates are low is a bad idea at this stage in the cycle. I'm not saying the cycle is about to end, but I am saying that now is not the time to just keep layering on more risk. I think it's better to kind of layer on more revenue streams or getting access to different parts of the market that are tied to different sources of revenue and cash flow.

Hetts: Okay, well this was a great conversation, Jim. I think we covered a lot of underappreciated and maybe unacknowledged aspects of inflation. So unique conversation to me and hopefully our listeners feel the same way. And as always, the views of Janus Henderson's other investment teams and thought leaders are freely available within the Insights section of our websites. We look forward to bringing you more conversations in the near future.