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Inflation: Tide, wave and ripple

Timely insights on the issues that matter most to investors.

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, Diversified Fixed Income Portfolio Manager, Eaton Vance Management and Jason DesLauriers, Diversified Fixed Income Trader, Eaton Vance Management

      Boston - Over the last few months, declines in energy and commodities, coupled with the risk-off market environment, have significantly reduced market-based inflation expectations. We believe that the decline in inflation breakeven rates represents an opportunity to add inflation assets to portfolios.

      While we hold a very constructive view on forward inflation, inflation base effects due to the decline in energy are likely to reduce year-over-year changes in the headline Consumer Price Index (CPI) over coming months.

      However, we also believe that the sharp decline in inflation breakeven rates already reflects much of this adjustment. Importantly, core inflation excluding food and energy costs is still above 2%. Given that energy is only an 8% weight in overall CPI, we think the odds of oil prices pulling core inflation substantially lower are remote.

      Blog Image Crude Oil Jan 2

      Inflation outlook and trends

      Classic investing literature often characterizes major trends as tide, wave and ripple.

      The tide describes the long-term secular trends. The wave describes the cyclic environment, while the ripple refers to shorter-term environment.

      While there is often some overlap, we tend to think of secular tides as trends lasting five years or longer, while cyclic waves have a lifespan of one to five years, and ripples generally last a year or less.

      Successful investors often focus on longer-term tides and waves, while either ignoring or using ripples to increase their factor exposure to the tide and wave. Over the last several years, we have made the following case in various blog pieces when it comes to inflation.

      The tide

      We believe the decades-long trend to lower inflation that started in the 1980s -- and accelerated in the era of rapid globalization of the 1990s and 2000s -- has ended. We think the transition took place in early 2016 when energy and commodity prices recovered from bear markets.

      The tide is now pushing inflation higher and will do so for at least the next five to 10 years, in our view. To be sure, there are some offsetting factors, such as the benefits derived from alternative energy technologies and expected gains in productivity. However, we believe the weight of the evidence is firmly in favor of a tidal change in the inflation backdrop.

      Here are some factors driving our view:

      • Demographics: Rising global dependency ratios will offer a tailwind to future inflation as they did in the 1950s and 1970s.
      • Central banks around the globe remain determined to achieve 2% inflation targets.
      • Inflation is a late-cycle development. This has been one of the longest expansions in history and many investable assets are behaving consistently with that idea.
      • There is finally a potential turn higher in the velocity of money.
      • A long-term change in commodities prices in which commodities begin to strengthen relative to financial assets. In other words, a change in the relationship between hard and financial assets that results in higher commodities prices.
      • A general reversal in globalization.

      The wave

      The wave supports higher inflation in the next one to five years. As we have discussed in past blog posts, inflation lags the current economy by roughly one to two years. A year ago, the domestic economy was moving sharply higher.

      These are some of the factors we see influencing the wave:

      • Central banks' monetary policy.
      • Full employment.
      • Clear signs of wage growth.
      • The closing of the output gap.
      • Institute for Supply Management (ISM) price indexes and surveys of pricing power.
      • The slope of the yield curve.

      The ripple

      As mentioned earlier, we believe that the long-term trend in commodities and energy turned from lower to higher in 2016. Despite the headwinds of increased oil production and the growth of alternative energies, we believe that the current decline is a ripple in the longer-term trend, due in part to these factors:

      • Sharp declines in oil and commodities.
      • Risk-off sentiment in financial assets that may translate to lower expectations for the real economy.

      Bottom line: Putting it all together, we think the tide and the wave clearly favor inflation-protection assets, and that ripples lower such as we are currently experiencing represent the opportunity to purchase them at below what we ascertain as fair market value.