Michael Gladchun, Associate Portfolio Manager for Loomis, Sayles & Company, joined Keith Black, Managing Director of RIA Channel, to discuss the inflation outlook and the impact on bond yields and equity valuations.
With data showing the inflation rate over the last three to six months running in the mid-2% area, Gladchun has an optimistic outlook on inflation, with predictions that inflation will continue to move toward the 2% level in the coming months.
Inflation is driven by supply and demand imbalances in three key areas of the economy: goods, services, and housing. The inflation rate in goods prices was the key during the pandemic. Supply chain shortages received lots of press during the pandemic, but those issues are now largely overcome, with supply and demand in the goods sector now relatively balanced.
Inflation in the service sector is driven by supply and demand imbalances in the labor market. The service sector was previously short eight million workers, but the supply of labor has grown to the point where today’s labor force is larger than the level projected before the pandemic.
The most elevated inflation readings are coming from the housing sector with that portion of CPI growing 7% on a lagged basis. It is important to remember that CPI measures the costs of housing rents, not the cost of purchasing housing. The dynamics of single-family homes differ sharply from multi-family homes. The supply of single-family homes is tight with the cost of purchasing a home near record highs considering both mortgage rates and home prices. In the rental market, however, multifamily valuations are down over 20% from peak prices and new construction supply is coming online at 30-to-50-year highs. As a result, the inflation rate on new residential leases is moderating.
In the long run, real rates matter. In the short run, nominal rates matter, as nominal growth rates are impacted by inflation, with wages, corporate revenues, and profits growing with inflation. Corporate revenues continue to grow as consumption is stable in the face of rising prices, as the consumer is somewhat insulated due to the increase of wealth and savings from stimulus. While nominal growth in 2022 was 7.5%, the real growth rate was less than 1%.
Bond investors are interested in both nominal yields and the ability of bonds to act as a hedge against stocks. Investors will pay more for bonds when they believe the correlation is diversifying relative to stock prices. In 2022, the rising correlation between stock and bond prices led to fewer correlation benefits between bonds and stocks, which led to bonds being less attractive.
Cross-asset correlations are impacted when stocks and bonds react differently to inflation. The correlation between stocks and bonds is higher during times of high and unstable inflation and lower during times of low and stable inflation. In the long run, it is hoped that stocks and bonds will have lower levels of correlation which brings greater diversification benefits. While the equity market is positively levered to changes in real growth rates, bonds have the opposite exposure, increasing in value as real growth rates decline. Currently, both bond and stock prices rise when the market anticipates declining inflation.
Bond prices currently seem low, as investors don’t seem willing to pay the 1.5% yield premium that is in place when stock and bond correlations are low. The bond market currently trades at a price discount or yield premium, but the correlation benefits are likely to return once inflation declines below 2.5%.
Gladchun notes that today’s yields are attractive. Investors may miss the opportunity to lock in today’s yields if they wait for clear signals of declining inflation. Those who believe that inflation will subside, a recession will be avoided, and the Fed will ease rates faster than market consensus can benefit from holdings in long-duration bonds. As inflation eases and correlation benefits return, investors may quickly return to bonds, increasing bond prices as yields and inflation expectations decline. Bonds provide a higher income than has been offered in many years with the potential for downside protection and the benefits of holding bonds in an environment of low and stable inflation.