Inflation has been relatively muted for decades. The long term trend has been down, with graphic representations looking similar to generational decreasing yield slopes. But we can’t help wonder, in a market in which animal spirits run amok, what will be the catalyst for an asset price bull market correction? We’ve long stated that looking at equity valuations in today’s markets can be misleading without incorporating absolute yield levels into the analysis. One can argue all they want that valuations are at historic highs, but when viewed in the context of nominal US Treasury yields buzzing around 1.5%, are US equity valuations so ridiculous? A world awash in liquidity forces capital to find a home. US Equities, real estate, credit – they are all fully valued.  With $13-$18 trillion in global debt carrying negative yields, even the 1.5% US Treasury 10-year looks attractive. But what if yields don’t stay so low? What is the catalyst that might force US Treasury yields higher?

Trade wars and the unfortunate corona-virus scare have clearly put downward pressure on yields. Though the US is running a trillion dollar deficit, the Treasury hasn’t had too much trouble finding willing lenders. Widely reported repo-market financing stresses have forced the Federal Reserve to inject liquidity to keep the money market functioning, but this has less to do with long term financing workings. However, those long term lenders aren’t really putting much of a premium on inflation concerns.

Consumer price inflation as measured by the CPI index less Food and Energy (not really sure who doesn’t pay for food and/or energy) has risen more than 2% for 22 straight months.

Arguments can validly be made that wage inflation has not accelerated. Even with US unemployment hovering around 3.5%, wage growth really hasn’t deviated much from +3.5% YoY for the last 2 years. So with Core CPI running above 2%, and wage growth running above 3%, why should TIPs implied breakeven inflation be only 1.6% over the next 10 years? Is the suppressing impact on growth emanating from the corona-virus outbreak really going to have such dramatic affect on global trade? For 10 years? The graph below shows the trailing 5 years of 10 year implied breakevens vs regular CPI YoY (you know, the kind of inflation that includes food and energy. It’s what’s used to calculate TIPs inflation adjustments). CPI has actually been running below Core CPI over the recent past primarily because of the global bear market in energy commodity prices. CPI is currently also above 2%, and that’s with crude oil trading in the low-$50s.

 

 

We don’t know if inflation is going to accelerate from current levels. Nonetheless, TIPs appear cheap. In a world of minuscule yields, these securities offer both some upside and a hedge against a correction in the equity markets. What would you suppose happens if inflationary expectations pickup and the US Treasury runs into even short term investor push-back finding a clearing price for its massive wave of future auctions? Short answer: rates go up, perhaps violently. An unforeseen spike in interest rates will cause an equity market correction. Always remember – markets react badly to negative surprises.

In the bond market at large, retail demand for California tax-exempt income continues unabated. The strength of the California economy lends current credence to the state probably having better credit quality that the typical non-financial Single-A corporate bond. Nonetheless, munis have lost almost all of the inherent attractiveness over other fixed income, liquid alternatives. In all terms, bond assets seem fairly comparable until you get to 10-year Tax-equivalent investments; 10-year paper should clearly be allocated to munis or corps. And as argued above, we think TIPS breakevens are relatively cheap across the term structure.

 

Legend: Yields are annualized. Taxable Equivalent Yield (TEY) assumes 37% Federal tax rate, 3.8% Medicare tax, 13.3% CA tax rate. CA Municipals are exempt from both Federal and State taxation, US Treasury securities are Federally taxable but exempt from State taxation. Corporate Bonds are fully taxable. Breakeven yields are the inflation rates over the term period in which investors are indifferent between owning US Treasurys and Treasury Inflation Protected Securities (TIPS)