DWS - Wed, 05/25/2022 - 15:33

The Fed, the Inflation Picture, and the Potential Impact on Insurance Fixed Income Portfolios

For much of 2021, the Federal Reserve (the Fed) had expected that inflation would be “transitory.” In previous discussions going back to July 2021, DWS’s outlook for inflation was to the contrary—that it would be longer-lasting and not transitory. Since then, our inflation outlook hasn’t changed.

Over the last few months, the markets have seen no shortage of headlines and speculation about inflation. Initially, the focus was on how the Fed would respond to the surge in inflation. Suddenly, that focus has shifted to how the Fed will respond to the fallout from the situation in Ukraine—and the economic and inflationary consequences of that conflict.

The Fed now finds itself in an even more precarious position than it was just several weeks ago. In this discussion, we shift our attention to the current challenges facing the Fed to offer perspectives on the fixed income markets and what insurance companies should focus on in positioning their investment portfolios going forward.

In the following Q&A with Robert McCollum, Head of Portfolio Management--Fixed Income Solutions, the rapidly changing dynamics of inflation are addressed, along with the increased attention on the Fed’s interest rate moves, the market impacts we anticipate, and DWS’s thoughts on positioning fixed income portfolios to adapt to this fluid situation.

You were not in the Fed camp that inflation would be transitory. What led you to that conclusion and how does that factor into your outlook going forward?

Putting aside the politicization of the Fed, we didn’t believe inflation would be transitory for a number of reasons.

First is the unprecedented monetary and fiscal stimulus we’ve had. M2 money supply expanded about $6 trillion over the past year. Then, underscoring that money creation, was another $5+ trillion of fiscal stimulus.

On top of that are the ongoing supply chain issues. What's happening at the West Coast ports has not improved, and now will be further exacerbated by the conflict in Eastern Europe.

Housing is another significant issue that’s going to drive inflation and the Consumer Price Index (CPI) for an extended period. We've had home price appreciation of roughly 18% in 2021. Underlying that was a shortage we estimated to be about 5.5 million units, with annual new home production running at about 1.4 million. We’re seeing inflation also reflected in rental prices, with the most recent statistics out of New York City indicating that year-over-year rents there are up 33%, so this demand/supply imbalance should help keep this data firm despite rising mortgage rates.

Similarly, demographics is something we've been highlighting for a long time. The prime age workforce is shrinking, not only in the U.S., but also in China. A recent study from an economics research firm looking at the labor force participation rate suggested that 80% of the recent decline in the U.S. is structural due to immigration and retirement factors. Therefore, when you combine this with record job openings in excess of 11.2 million, these drivers will buttress continued wage pressures via a tight labor market.

With respect to the most recent developments in Ukraine, certainly the supply chain issues are going to be aggravated further. For example, Ukraine produces 70% of neon globally, which is a big component in the manufacture of semiconductors, impacting not just automobiles but durable goods like washing machines and refrigerators. Russia is a major producer of nickel, which is an important component for electric vehicle (and other) batteries and is also used in many other alloys including stainless steel.
Ukraine and Russia are large producers of wheat, with Ukraine also growing a significant corn crop. Additionally, Russia is also one of the biggest fertilizer producers, so this conflict is going to have a dramatic impact on food prices.

Finally, there is energy, with headline numbers that continue to go higher with the imposed sanctions. Exacerbating that is the decline in U.S. production to around 11.5 million barrels/day and a change over the past year to an unfriendly regulatory climate for exploration, production, and the import of Canadian oil.

The bottom line is that inflation is a pernicious tax, with benefits for debtors. With $30 trillion in debt, the U.S. is going to be a beneficiary. Frankly, we don't believe the Fed has the political will to tighten enough to bring inflation down to anything near the 2% target rate, so it looks like inflation is going to be with us for some time.

The strategy for insurance company investment portfolios is to be patient and let the bond market reprice itself. Continue to keep a close eye on what's happening in the risk asset markets, because if you get a replay of 2018 where equities and the credit markets seized up, then that’s going to limit how much the Fed tightens policy, which is not going to help in terms of arresting inflation.

At the beginning of the pandemic, we saw a move away from risk assets. Now, with what's going on in Ukraine, we again have more market volatility, equities selling off, and widening credit spreads, which will likely continue for the near term.

With this inflation outlook, to what extent does the speed and magnitude of the Fed’s rate increases form your investment decision-making and positioning today? And how does that factor into what you're seeing in the market?

The market has already priced in approximately eight additional Fed rate hikes for this year. The rally in U.S. Treasuries that occurred in early to mid March, to the 1.70% area in 10-year notes was driven largely by short covering. Now that a lot of the shorts have been covered, we're selling off. The risk if the Fed moves too slowly is probably a steepening of the yield curve.

If growth holds on, and the Fed is too cautious—and they've certainly been late to the party in terms of tightening—the yield curve steepening scenario could play out. The more likely scenario is that the Fed goes along with the anticipated number of hikes over the course of the year, growth does slow, and the yield curve flattens further. If we do get inversion in the yield curve, it's historically presaged a recession in a little over a year’s time. Therfore, I’m cautious both in terms of rates and spread sectors.

Going into the March Federal Open Market Committee (FOMC) meeting, were there certain statements you were looking for from Fed Chairman Jerome Powell?

The quantitative easing (QE) the Fed commenced during the pandemic resulted in about $6 trillion in total securities purchased. Now that QE has ended the Fed has a significant balance sheet that also could be utilized to tighten policy. In terms of anticipated comments, I was looking for how their outlook changed on inflation and how this would move the median forecast for the Fed Funds rate. The Fed clearly has been more focused on tightening policy via raising the Funds rate rather than on balance sheet reduction; they haven't wanted to pull those two levers simultaneously at the onset. However, with the balance sheet at around $8.5 trillion, we're certainly in uncharted waters.

I am anxious to see more clarity on the balance sheet in May. We believe the Fed is going to want the balance sheet runoff to happen quietly, with caps and operating in the background. However, a more aggressive course of action, though unexpected, could serve to tighten policy more quickly.

As a bond investor, what are the macro or market factors influencing your outlook and driving your portfolio decisions?

From the macro standpoint, there are a number of factors that influence our outlook and decisions.

Inflation is clearly one of them. Many investors had expected inflation to peak in March, but with ongoing issues in the energy and commodity sectors a decline in that trajectory may occur more slowly.

Growth of the economy is another. There's been a lot of talk about stagflation unfolding, and policy tightening should cause a moderation in growth. Consumer sentiment has been moving down and recently was the weakest since 2011, so that is something to monitor.

Energy policy is a third factor. While we saw a recent pivot with the political pressure to sanction Russian energy imports, there’s obviously more the U.S. can do in terms of domestic production versus relying on “less-than-friendly” countries for energy supply. However, with recent comments about oil company “profiteering,” we are not holding out a lot of hope for a policy shift. That will further impact both growth and inflation unless there is any policy reversal.

In terms of the markets, there are a number of other things we are watching. The Equity Volatility Index (VIX) peaked at just above 36 in early March, but risks remain that this Index could move higher after the recent retrace. The forward S&P 500 price-earnings (P/E) ratio is around 18, with 3x price-to-sales numbers. If interest rates move higher, those numbers could fall. Currently, and granted the markets are moving quickly, U.S. equity markets look to be a bit oversold, and we could be range-bound for a bit. That will impact corporate spreads, which were at 124 basis points (bps) in option-adjusted spreads over U.S. Treasuries for the corporate index on March 1. That number gapped up to 142 bps about a week later. Corporate issuers have pulled back a little, although we continue to see some deal flow. Some have posited that corporate spreads broaching +150 bps may give the Fed pause, and perhaps that level will cap spreads near-term. In any event, as real rates become less negative during the tightening cycle, spread assets could remain under pressure.

For people who had been paying attention to it, the Commodity Research Bureau (CRB) Index really told the inflation story—and it’s one of the indicators we've been monitoring closely. If you go back to two years ago, the CRB Index was 80% lower than where it was in early March.

We believe those are the most important trends to keep an eye on both from the market and macro standpoints.

In navigating through an environment like this one, do you make investment decisions with more of a “wait- and-see” approach, where you tactically adjust to what the market is doing? Or do you think about it as a longer-term change in strategy, where you are making a macro-positioning decision?

When we’re speaking to insurance companies about investing their fixed income portfolios, we sometimes use the analogy that it’s similar to being at the helm of an aircraft carrier. You are not aggressively making short-term, total return-type trades, like using derivatives, holding very large cash positions, or taking lots of gains and losses. Rather you are trying to build positions and a portfolio that can capitalize on a longer-term plan and can then change course when necessary—whether that’s in terms of duration, sector, or credit quality—as you see opportunities to add risk or be more defensive.

As we've watched yields move to levels we haven't seen in a few years, it's tempting to be aggressive adding risk here. Given that the fundamental backdrop remains quite good, it’s probably okay to “nibble around the edges” and add some portfolio book yield via spread sectors, but ultimately today’s environment is one that requires patience.

It’s clear from what we just discussed that there are a lot of flashing red and yellow signals. We've anticipated a number of these and felt comfortable with decisions such as being short duration and barbelled, with positions in floating rate bonds and an underweight to mortgage-backed securities. We continue to believe there will be opportunities to add value, but we must remain patient to make sure we're maximizing that opportunity.

Lastly, what should investors consider either from a “market observation” or asset class standpoint?

Given the various factors we’ve cited that may limit the Fed from tightening aggressively to arrest inflation, investors must be prepared for inflation to be with us for a while.

From an asset class standpoint, while our focus is predominantly on fixed income, we also keep our eyes on other markets to maintain a broader perspective and provide context. It's not necessarily too late to diversify one’s portfolio into asset classes that can offer protection against sustained levels of inflation, whether that's opportunities from real estate via appreciation or higher income from rent increases, or from investments in other real assets such as infrastructure, commodities, etc. From a capital efficiency standpoint, mezzanine private debt with an investment grade wrapper can offer yields that keep pace with current inflation.

These are some areas to consider where one can add diversification and income while helping insulate a portfolio against long-term inflation headwinds.

Download PDF Reprint

For Institutional Investor use only. Past performance is not indicative of future returns.
Forecasts are based on assumptions, estimates, opinions,, and hypothetical models that may prove to be incorrect. Investments come with risk. The value of an investment can fall as well as rise and your capital may be at risk. You might not get back the amount originally invested at any point in time.

DWS is the brand name of DWS Group GmbH & Co. KGaA and its subsidiaries under which they do business. The DWS legal entities offering products or services are specified in the relevant documentation. DWS, through DWSGroup GmbH & Co. KGaA, its affiliated companies and its officers and employees (collectively “DWS”) arecommunicating this document in good faith and on the following basis.
This document is for information/discussion purposes only and does not constitute an offer, recommendation orsolicitation to conclude a transaction and should not be treated as investment advice.
This document is intended to be a marketing communication, not a financial analysis. Accordingly, it may notcomply with legal obligations requiring the impartiality of financial analysis or prohibiting trading prior to thepublication of a financial analysis.
This document contains forward looking statements. Forward looking statements include, but are not limited toassumptions, estimates, projections, opinions, models and hypothetical performance analysis. No representation orwarranty is made by DWS as to the reasonableness or completeness of such forward looking statements. Pastperformance is no guarantee of future results.
The information contained in this document is obtained from sources believed to be reliable. DWS does notguarantee the accuracy, completeness or fairness of such information. All third-party data is copyrighted by andproprietary to the provider. DWS has no obligation to update, modify or amend this document or to otherwise notifythe recipient in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forthherein, changes or subsequently becomes inaccurate.
Investments are subject to various risks. Detailed information on risks is contained in the relevant offeringdocuments.
No liability for any error or omission is accepted by DWS. Opinions and estimates may be changed without noticeand involve a number of assumptions which may not prove valid.DWS does not give taxation or legal advice. This document may not be reproduced or circulated without DWS’s written authority. This document is not directed to, or intended for distribution to or use by, any person or entity who is a citizen orresident of or located in any locality, state, country or other jurisdiction, including the United States, where suchdistribution, publication, availability or use would be contrary to law or regulation or which would subject DWS toany registration or licensing requirement within such jurisdiction not currently met within such jurisdiction. Persons into whose possession this document may come are required to inform themselves of, and to observe, suchrestrictions.
This document may not be reproduced or circulated without DWS written authority. The manner of circulation and distribution of this document may be restricted by law or regulation in certain countries, including the United States.
War, terrorism, sanctions, economic uncertainty, trade disputes, public health crises and related geopolitical events have led, and, in the future, may lead to significant disruptions in U.S. and world economies and markets, which may lead to increased market volatility and may have significant adverse effects on the fund and its investments.
This document is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisfsdiction, including the United States, where such distribution, publication, availability or use would be contrary to law or regulation or which would subject DWS to any registration or licensing requirement within such jurisdiction not currently met within such jurisdiction. Persons into whose possession this document may come are required to inform themselves of, and to observe, such restrictions.
© 2022 DWS International GmbH
Issued in the UK by DWS Investments UK Limited which is authorised and regulated in the UK by the FinancialConduct Authority.
© 2022 DWS Investments UK Limited
This document is issued by DWS Investments Hong Kong Limited (“DWS HK”) and is the property and copyright of DWS HK. This document may not be reproduced or circulated without DWS HK’s written consent. The mannerof circulation and distribution of this document may be restricted by law or regulation in certain countries, including the United States. All rights reserved.
© 2022 DWS Investments Hong Kong Limited
In Singapore, this document has not been reviewed by any regulatory authority. This ddocument has been prepared solely for informatonal purposes and does not constitute an offer or arecommendation to enter into any transaction. The terms of any investment will be exclusively subject to thedetailed provisions, including risk considerations, contained in the offering documents. When making aninvestment decision, you should rely on the final documentation on relating to the transaction. The value of an investment and any income from it can go down as well as up. Past performance is not a reliable indicator offuture result
© 2022 DWS Investments Singapore Limited
In Australia, this document is issued by DWS Investments Australia Limited (ABN: 52 074 599 401) (AFSL 499640) and the content of this document has not been reviewed by the Australian Securities Investment Commission.
© 2022 DWS Investments Australia Limited
In Taiwan, this document is distributed to professional investors only and not others. Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or asolicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed, and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.
For investors in Bermuda
This is not an offering of securities or interests in any product. Such securities may be offered or sold in Bermuda only in compliance with the provisions of the Investment Business Act of 2003 of Bermuda which regulates the sale of securities in Bermuda. Additionally, non-Bermudian persons (including companies) may not carry on or engage in any trade or business in Bermuda unless such persons are permitted to do so under applicable Bermuda legislation.
For Investors in Canada. No securities commission or similar authority in Canada has reviewed or in any way passed upon this document or the merits of the securities described herein and any representation to the contrary is an offence. This document is intended for discussion purposes only and does not create any legally binding obligations on the part of DWS Group. Without limitation, this document does not constitute an offer, an invitation to offer or a recommendation to enter into any transaction. When making an investment decision, you should rely solely on the final documentation relating to the transaction and not the summary contained herein. DWS Group is not acting as your financial adviser or in any other fiduciary capacity with respect to this proposed transaction. The transaction(s) or products(s) mentioned herein may not be appropriate for all investors and before entering into any transaction you should take steps to ensure that you fully understand the transaction and have made an independent assessment of the appropriateness of the transaction in the light of your own objectives and circumstances, including the possible risks and benefits of entering into such transaction. You should also consider seeking advice from your own advisers in making this assessment. If you decide to enter into a transaction with DWS Group you do so in reliance on your own judgment. The information contained in this document is based on material we believe to be reliable; however, we do not represent that it is accurate, current, complete, or error free. Assumptions, estimates and opinions contained in this document constitute our judgment as of the date of the document and are subject to change without notice. Any projections are based on a number of assumptions as to market conditions and there can be no guarantee that any projected results will be achieved. Past performance is not a guarantee of future results. The distribution of this document and availability of these products and services in certain jurisdictions may be restricted by law. You may not distribute this document, in whole or in part, without our express written permission. For Institutional Use and Registered Rep Use Only. Not for Public Viewing or Distribution.
For investors in Peru / Argentina / Chile / Mexico / Brazil:
This marketing communication is intended for professional clients only. DWS is the brand name under which DWS Group GmbH & Co. KGaA and its subsidiaries operate their business activities. Clients will be provided DWS products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services. The information contained in this document does not constitute investment advice. All statements of opinion reflect the current assessment of DWS Distributors, Inc. and are subject to change without notice. Forecasts are not a reliable indicator of future performance. Forecasts are based on assumptions, estimates, opinions and hypothetical performance analysis, therefore actual results may vary, perhaps materially, from the results contained here. Past performance, [actual or simulated], is not a reliable indication of future performance. The information contained in this document does not constitute a financial analysis but qualifies as marketing communication. This marketing communication is neither subject to all legal provisions ensuring the impartiality of financial analysis nor to any prohibition on trading prior to the publication of financial analyses. This document and the information contained herein may only be distributed and published in jurisdictions in which such distribution and publication is permissible in accordance with applicable law in those jurisdictions. Direct or indirect distribution of this document is prohibited in the USA as well as to or for the account of US persons and persons residing in the USA.
For investors in Colombia: This document does not constitute a promotion or marketing of financial products or services in the Republic of Colombia. The information contained is not the result of any advertising or promotional activity of DWS in Colombia. This information is for educational purposes and is not investment advice. This information has not been filed with the local regulator in Colombia. DWS is not licensed to promote or market financial products or services in the Republic of Colombia. DWS Investments UK Limited is authorized and regulated by the Financial Conduct Authority in the UK.

© 2022 DWS Group GmbH & Co. KGaA. All rights reserved. I-088992-1


Sign Up Now for Full Access to Articles and Podcasts!

Unlock full access to our vast content library by registering as an institutional investor .

Create an account

Already have an account ? Sign in