by Brad Houle, CFA
Executive Vice President
On Tuesday this week, inflation data as measured by the consumer price index (CPI) for the month of March was reported at 2.6 percent. This year-over-year inflation reading was significantly higher than it had been trending over the past few months. This distortion of inflation has occurred due to the significant disinflation that was experienced during the height of the COVID-19 crisis from 2020.
This effect will likely become even more pronounced as we move through the next three months. Our view is that this elevated inflation will be fleeting as the disinflationary forces that were present in the economy will remain after the pandemic. Globalization of labor, aging demographics and technology driving consumer prices lower are three factors that have kept a lid on inflation in the developed world.
Inflation has been in the news and has been top-of-mind for many clients. Inflation is the enemy of bonds because sharply increasing inflation erodes the value of the fixed payments from bonds. The U.S. Treasury comes armed with Treasury Inflation Protections Securities (TIPS), which are bonds designed to be a hedge against inflation. Much like normal Treasury bonds, TIPS bonds pay coupon income twice a year. In addition, the principal value of the bonds increases or decreases based on changes in the CPI.
The time to own TIPS bonds is when inflation expectations are low and moving higher. At the moment, we are in an environment where we believe inflation has only temporally spiked upward due to the pandemic-induced economic shutdown. In addition, they are less liquid than traditional Treasury bonds and tend not to be as defensive as normal treasury bonds during turbulent market and economic events.
Companies are beginning to announce first quarter earnings. Investors will be closely watching the forward guidance for earnings from companies to see the impact of massive government stimulus and the economy reopening. This week, retail sales were released for the month of March with an impressive gain of 9.8 percent as consumers venture out of their homes with the largest increase in spending on airline tickets and clothing. Bonds traded higher this week with the 10-year Treasury yield moving from a 1.66 percent to 1.59 percent. Stocks traded higher this week with the S&P 500 up 1.38 percent for the week.
Week in Review and Our Takeaways for the Week
The elevated inflation that we are expecting for the next few months will be transitory
TIPS bonds are an imperfect hedge against elevated inflation that we do not see as a risk over the investable time horizon