Why Bernstein Thinks Inflation May Have Bottomed Out

Inflation on the rise?

Inflation may be on the rise. At least Richard Bernstein Advisors thinks so. In the annual “Charts for the Beach” piece of the Insights newsletter, Richard Bernstein opined that inflation may be rising in the US.

To substantiate his viewpoint, he provided a chart of the five-year five-year forward breakeven. Calling it “supposedly the Fed’s favorite measure of inflation expectations,” he pointed to the fact that inflation expectations may have bottomed out in February 2016 with the stock market bottom. A five-year break-even inflation chart is provided below for your reference.

[marketrealist-chart id=1556431]

Incorrect portfolio positioning?

If inflation is indeed on the rise, Richard Bernstein said that equity and fixed income portfolios could be in for a rough time. A rush towards fixed income products at a time when inflation expectations have bottomed out seems out of sync with what the trend should be.

If inflation is rising, one would expect investors moving away from bonds and debt funds and shortening duration quite sharply. Duration measures the interest rate sensitivity of the price of a bond (AGG) (BND). The higher the duration, the more sensitive its price is to a change in interest rates.

When inflation rises, a central bank stands ready to take policy actions that ensure that inflation doesn’t gallop and remains within its target range, if any. The US Federal Reserve is mandated to keep inflation at a 2% rate in the longer term.

As outlined above, higher duration is more sensitive to a change in interest rates. Thus, the higher exposure to fixed income, as shown by low bond yields in the US, could prove hurtful to investors if inflation rises. Corporate bond yields, as measured by the BofA Merrill Lynch US Corporate Master Effective Yield, are down to 2.8% currently from 3.7% at the beginning of the year. Meanwhile, high yield bond yields, as measured by the BofA Merrill Lynch US High Yield Effective Yield, are down to 6.4% at present compared to a high of 10.1% seen on February 11, 2016.

Companies like Duke Energy (DUK), Amgen (AMGN), and Berkshire Hathaway (BRK.A) have hit the primary market to issue bonds at comparatively low yields, some in anticipation of higher interest rates in the future that would increase their interest payments.

Richard Bernstein Advisors is not alone in thinking that inflation may rise in the near future. The Janus Asset Allocation team recently published a note that makes the same point.

Coming back to financial markets, Richard Bernstein showed that investors are hating equities right now. Let’s look at that in the next article.