SCHP - SCHP: Reveals Lack Of Realism In Inflation Picture

2023-12-11 14:15:00 ET

Summary

• We think U.S. bond markets are underestimating how difficult it might be to fight inflation. We'll have confirmation one way or another starting next Tuesday.
• Schwab U.S. TIPS ETF™ contains TIPS, and an effective duration of around 7 years, where the implied expectations for inflation are too low and therefore the SCHP ETF is attractive.
• However, the duration and sensitivity to changes in real rate assumptions is a reason why we would opine that additional caution should be taken in addition to caution around macro.

The Schwab U.S. TIPS ETF™ ( SCHP ) contains a portfolio of TIPS. We posit that the U.S. bond markets, which are pricing in around 2.1% inflation annualized over the next 10 years, are not on the right track in terms of their assessment. We think that high inflation rates will continue to disappoint markets with its stickiness, and a big culprit, in addition to a still strong labor market, is going to be the continuously high inflation expectations. Pricing in normal 2% annualized inflation over the next several years seems unreasonable to us.

SCHP Breakdown

SCHP contains TIPS and the effective maturity is around 7 years , where typical maturity is going to be around 10 years. Current TIPS yields are around 2% . The expense ratios are fantastic at around 0.03%, which is excellent for a fixed income portfolio.

Current 10Y yields are around 4.2% , which means that implied annualized inflation rates over that period are implied at around 2.2%.

We don't think that's realistic and that inflation could be higher. There are several reasons. The first is simply that unemployment remains low , and while there is some slight slack in the job market, it's not enough at this point in time.

We also think that the fact that European inflation is coming down isn't a proper signal for the evolutions of the U.S. inflation and general rate situation. It's more than just the different sensitivity to the initiation of the Ukraine war and the supply side impacts that followed, nor the commonalities in sharing a global market for a lot of commodities including oil and gas. The economies are fundamentally different, and consumer dynamics are fundamentally different, which also means that inflation expectations have been fundamentally different.

Inflation is a self-fulfilling prophecy. If for whatever reason consumers believe there will be inflation, that will be baked into wage negotiations and producers will try pass on that inflation as soon as possible to consumers thereby closing the loop and fulfilling the prophecy. It is entirely possible that inflation expectations can anchor differently in the US compared to the EU.

Indeed, inflation expectations are quite high in the U.S. In December 2022, inflation expectations were 3.4% for 2023, and now inflation expectations are 3.1% for 2024. 5 year expectations are 2.8% . One of the reasons why FOMC comments have been focused on the fact that the Fed would have to be aggressive with rates is because the inflation needs to start falling fast. The longer they linger at higher levels the more crystallized expectations become.

We think the optimism of credit markets is undermining current Fed efforts, as credit market optimism means better credit conditions, and the constant disappointments about the state of inflation may crystallize expectations more quickly. The fact that market expectations of falling inflation also accompany job market data that suggests inflation will stay high is not helpful either, as unemployment continues to tick lower. Market expectations may influence consumer expectations through financial headlines.

Another dimension of differences between U.S. and EU consumers is just the rate of consumption, which leads into money velocity. That has also limited the transmission mechanism of the Fed and caused rates to go higher without yet having a meaningful effect on the economy, since the working money in immediate circulation remains plentiful.

Bottom Line

The state of consumer inflation expectations is ultimately the most concerning factor, and runs contrary to how financial markets have decided to value TIPS. Implied 2% inflation rates could be too low, and we think the cumulative argument above means that they are more likely to be too low than not. As such, TIPS actually look relatively attractive, as they would outperform as market expectations around inflation might be revised upwards. We'd prefer TIPS for the moment over Treasuries, but do note that duration effects still matter for TIPS too, and the SCHP TIPS are pretty long duration and will be sensitive to changes in real rate assumptions by markets which are the basis on which TIPS are valued.

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