Indeed, with unemployment rates at a 16-year low, it’s surprising that we have yet to see a more robust pace of wage gains. Still, Temple thinks that inflation could move toward the 3.0% mark in 2018 as employers begin to dole out stronger wage increases to retain and attract staff. Temple adds that “we could end up with a more protectionist trade policy that also could prove to be inflationary.” Moreover, the dollar has fallen sharply against a basket of currencies, which has begun to lead to rising import prices.
If Temple is right that inflation will soon trend higher, then investors should consider adding inflation protection strategies, such as Lazard’s real assets fund (RALIX), to their portfolios.
While inflation trends deserve your close attention, also keep an eye on the Federal Reserve this winter. Janet Yellen’s term as Fed chair expires at the end of 2017, and several members of the FOMC are also likely to step down in January. “The composition of the Fed is going to change pretty dramatically,” predicts BlackRock’s Rosenberg. “So it’s hard to form a view of longer-term Fed policy.” The BlackRock Core Bond Fund (BCBAX) is among his firm’s fixed-income offerings.
The changeover in the FOMC will take place at a time when the Fed is unwinding its massive $4.2 trillion portfolio of mortgage and Treasury bonds. “The Fed doesn’t yet fully understand the extent that the QE (quantitative easing) process actually impacted rates,” says TIAA Investments’ Nick. “It’s hard to know in advance what the impact of the unwinding will be.” At a conference in Paris this past summer, Jamie Dimon, CEO of JPMorgan Chase, said the balance sheet shift “could be a little more disruptive than people think.”
Moving Beyond Plain Vanilla
Few strategists interviewed for this story recommend 10-Year Treasurys or investment-grade corporate bonds, the kinds of bonds you would find in the Bloomberg Barclays U.S. Aggregate Bond Index. Thanks to the low yields they currently offer, such plain vanilla bonds have only modest potential for price gains. And the income from those low yields might be fully offset by a drop in bond prices as rates rise. In a recent note to clients, TIAA’s Nick noted that “from 1990 to 2005, [the Bloomberg Barclays aggregate index] returned close to 7.5% per year, on average. But the current yield of just 2.5% makes duplicating that strong performance unlikely.”
That doesn’t mean you should simply shun fixed-income investments in general. “It’s critical that you have the diversifying value of bonds in your portfolio,” says BlackRock’s Rosenberg. To get that portfolio ballast, it may be wiser to instead seek out other corners of the bond market for more enticing yields or lower interest rate risk—for example, high-yield (i.e., “junk”) bonds or floating-rate funds.
TIAA’s Nick has a preference for the floating-rate funds. “They often have higher credit quality yet offer the same yield as junk bonds.” He added in a recent client note, “When rates are rising, investors in floating-rate loans generally earn higher income and experience smaller price declines.” The Credit Suisse Floating Rate High Income Fund (CHIAX) is a popular choice in this category.
Floating-rate funds are part of what PIMCO’s Kiesel refers to as “safe spreads.” He says that “in the later stages of an economic expansion, you want to move up the capital structure. And bank loans are senior debt, compared to general bonds [such as high yield] that are lower in the capital structure.” Subordinated debt, which most general bonds are, carry higher default risk if the economy were to slow down. Kiesel thinks junk bonds “just aren’t appealing later in the economic cycle.”
Ample Reasons to Wade Into Emerging Markets Bonds