By Jamie Lewin and Alicia Levine
In part one of this three-part series, we discussed three broad economic policy pivots embraced by the Trump administration and the resulting market implication to global reflation, the first of three investible themes BNY Mellon Investment Management is watching closely in 2017. Part II dives into our second investible theme, inflation and rising rates, and the corresponding actions investors should consider in 2017. We approach this from the perspective that some investors seek to achieve some combination of sustainable income, long-term capital growth and/or capital preservation.
Inflation and Rising Rates
The reflationary policies of the new Trump administration, coming on top of recent moves in inflation rates are likely to send inflation expectations higher still. The starting point of near- full employment points to limited slack in resource markets such that any significant acceleration in aggregated demand growth will ultimately lead to rising good and service sector prices. Markets have already begun to price in the growing risk of this outlook as medium term inflation expectations in the U.S. have moved higher, as they have in Europe and Japan. All recent data point to a global uptick in inflation expectations.
The 10-year Treasury yield jumped at the end of 2016 and expectations are that it will move higher in the next 12-18 months as the Fed is poised to raise rates two or three times in 2017 and possibly hike three to four times in 2018. Fixed income portfolios therefore are faced with duration and re-investment risk, which is unlikely to be fairly compensated in 2017.
Investment Strategy Implications
Distilling these market views into a series of investment conclusions yields a range of possible actions investors should consider in 2017. With this in mind, BNY Mellon Investment Management believes that investors need to evaluate whether the preconceived investment risks inherent in their asset allocations can be compensated given the anticipated market environment. Of the risks that are typical of most investor portfolios we focus on those that are most likely to adversely affect investors’ portfolios if unaddressed.
Nominal Interest Rate Duration
While it may still be too early to call the end of the three decade bull market in interest rates, the balance of risks has clearly and meaningfully shifted to the upside. This is a risk that directly and indirectly permeates many elements of an investor’s portfolio through exposure to fixed income and other interest rate sensitive asset classes. Unaddressed, rising interest rates can jeopardize both the income seeking and capital preservation goals of investors.
Possible actions to mitigate this risk include the reallocation of capital towards unconstrained multi-sector fixed income products, greater global fixed income market exposure, increased exposure to floating rate cooperate debt / private debt, corporate credit, investment in laddered bond structures and other “hold-to-maturity” strategies.
Rising Inflation Expectations
Inflation is a silent killer. For investors whose portfolios comprise predominately financial assets backed by nominal cash flows such as coupons and dividends, inflation erodes the purchasing power of these cash flows and therefore impairs the value of the financial asset supporting the cash flows. Inflation risks for now remain nascent; however, it is imperative that investors consider allocating a greater share of their capital to assets with greater embedded inflation protection as we expect upside inflation risks to increase going forward.
Possible actions to mitigate this risk include greater exposure to real assets such as commodities and commodity linked equities, TIPS, real estate and infrastructure. This can be achieved either through individual asset class exposure or via blended multi-strategy approaches.
Jamie Lewin is Managing Director and Head of Product Strategy, and Alicia Levine is Director of Portfolio Market Strategy, BNY Mellon Investment Management