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40 years of declining inflation may be creating a new bias trap for investors

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Stewart D. Taylor, Investment Grade Fixed Income Portfolio Manager, Eaton Vance Management and Jason DesLauriers, Investment Grade Fixed Income Trader, Eaton Vance Management

      Boston - The cover of the April issue of Bloomberg Businessweek magazine featured a badly crumpled Tyrannosaurs Rex balloon with a bold headline that rhetorically asked "Is Inflation Dead?" We think the answer is a resounding no. It remains our view that the 40-year decline in the inflation rate ended in 2015. (See our January post titled "Inflation: Tide, wave and ripple" on the right for a detailed discussion). Developments over the last few months have strengthened the case.

      The April employment situation report is a good example. Very low unemployment has historically translated to higher wages and, via wages, to higher inflation. For instance, in late 1968, the unemployment rate was 3.4%. This translated to headline CPI at 4.5% that eventually crested above 6% two years later. In 2000, the unemployment rate fell to 3.8%. This time, inflation rose as high as 3.8% where it stayed for most of a year before weakening again. The current unemployment rate of 3.6% is the lowest in 50 years. (Source: Bloomberg, May 2019). We think it is only a matter of time before the demand for employees translates into higher wages and higher inflation.

      Recency bias and inflation

      Recency bias is the cognitive flaw that results in human beings assigning a high value to recent information while simultaneously assigning a low value to older information. In practical terms, investors sometimes extrapolate recent returns into the future while they pay scant attention to the important lessons of the past.

      Other than a short period in 2008, inflation has been a non-factor for 40 years. A portfolio manager or investor, 30 years old when inflation peaked in 1980, is now 70. When viewed through the lens of behavioral economics, it comes as no surprise that the "great inflation" of the 70s represented the defining event of their investing career.

      I remember attending an investment conference in the mid-1990s. 10- and 30-year Treasury rates were both around 8.0%. Rather than viewing 8.0% nominal returns for the next 20 years as a magnificent buying opportunity, attendees were adamant that the next big move in inflation and rates would be higher. They were extrapolating their experience with the extreme inflation of the 70s forward into the 90s and 2000s. As a result, they missed one of the most profitable bond bull markets of all time as disinflation allowed rates to decline for the next two decades.

      Now, 40 years of declining inflation may be creating a new bias trap for investors. It is likely that inflation hedges are under-represented in their portfolio and that they will be slow to react when inflation does show up. More troubling, the central bankers who dealt with the inflation in the 70s are long retired. If inflation begins to rise again, recency bias at the Federal Reserve may well inhibit a timely policy response.

      The current inflation picture

      We often make the point that large changes in crude oil generally translate to large changes in headline CPI. That has certainly been true over the last six months. Last fall, spot WTI crude declined 45%. This sharp decline translated to three sequential monthly headline CPI prints of 0.0% and dropped the year-over-year (YOY) headline as low as 1.5% in February. Now, crude has rallied 57% from its December low and YOY headline CPI has moved back to 2.0%. Core Services continue to increase at a strong 2.8% YOY, while the core goods component is slightly lower at -0.2% YOY. Shelter costs continued to push inflation higher, with rents increasing at a 3.80% annual rate.

      Bottom line: This late stage in the business cycle inflation and real return assets potentially offer value and important portfolio diversification benefits. Short duration TIPS, floating rate instruments and bond ladders continue to be our vehicles of choice.

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