Preparing for Higher Inflation
* Outlook: higher inflation expectations pose a risk to bonds: The prospect of higher inflation during a modest slowing of economic activity presents something of a mixed bag for fixed income investors. Slower growth is generally associated with lower real rates, whereas the threat of increased inflation is directly reflected through higher nominal rates. In our view, bonds have already repriced for slower growth but are more complacent about inflation risks.
* Duration: minimize interest rate risk, maturity extension: After incorporating revised growth and inflation estimates, our fair value model suggests 10-year Treasury note yields should trade closer to 5.0% in the next year. Therefore, we recommend that investors maintain an underweight duration exposure. However, we recommend scaling back the duration underweight to 95% from 92% of a neutral allocation.
* Yield curve: limited room for additional flattening:
With term spreads likely to remain within a narrow range, risk-adjusted returns across the curve are apt to be fairly uniform. However, our preference for a shorter-duration profile suggests that laddering across the short to intermediate sectors and underweighting the long end is a more appropriate tactical curve allocation.
* Sectors: overweight inflation-protected securities:
Based on our outlook for higher inflation expectations, we recommend that investors overweight inflation-protected securities.
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