BBH Inflation-Indexed Fixed Income Quarterly Update

BBH Inflation-Indexed Fixed Income Quarterly Update – Q2 2024

June 30, 2024

Capital Partners

Portfolio Managers, James Evans & Jorge Aseff, provide an analysis of the investment environment and most recent quarter-end results of the Inflation-Indexed Fixed Income strategy.

Q2 Highlights

Investors have become more sensitive than usual to economic releases, as rates rally or sell off depending on downside or upside surprises, respectively.
Our portfolios ended Q2 2024 ahead of the benchmark, bringing relative year-to-date performance to 23 basis points.
After three consecutive upside surprises, Consumer Price Index (CPI) inflation moderated in Q2. Measured by annual changes in CPI, headline and core inflation are 3.0% and 3.3%.

Are We There Yet?

Anyone who took a recent road trip might have noticed children no longer ask, “are we there yet?”, every 10 minutes of a four-hour car ride. Today, sophisticated navigation systems provide the exact location and estimated time of arrival throughout the journey. Since financial markets do not have a navigation system for monetary policy, investors and the press often ask the Federal Reserve (Fed), “are we there yet?”, referring to the point at which the Fed will begin easing the policy rate. Furthermore, although the Fed has always gauged progress toward policy objectives with data, investors have become more sensitive than usual to economic releases, as rates rally or sell off depending on downside or upside surprises, respectively.

About a month into the second quarter, data suggested some moderation of economic activity and rates rallied on the expectation the Fed might ease policy sooner than anticipated. The rally did not offset the sell off experienced at the beginning of the quarter, when higher-than-expected inflation and labor market strength lifted the 10-year real yield 40 basis points.¹ For the quarter, 10-year real yields increased 23 basis points, while 10-year market-implied inflation expectations (breakevens) remained practically unchanged. Realized inflation exceeded breakevens by about 1%, and Treasury Inflation-Protected Securities (TIPS) outperformed nominal Treasuries in Q2 2024 by 0.69%. Remarkably, as nominal Treasuries lost 1.9% in the first half of 2024, TIPS gained 0.7%.

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Exhibit I: A table displaying real yields and breakevens for inflation-indexed markets as of June 30, 2024.

Portfolio Positioning and Performance

Our TIPS portfolios own 10-15 securities out of dozens available in the Bloomberg U.S. Treasury Inflation-Linked Index (the benchmark). Relative to the benchmark, our positions favor short-maturity TIPS over intermediate. This curve structure would benefit from a steepening in the front of the curve, which remains severely inverted (see Exhibit IIa). The contrast between today’s real yield curve and the 2000-2019 average is especially stark around maturities shorter than 5 years. Similarly, with real yields still elevated late in the Fed’s cycle, we maintained a small duration overweight in most of Q2.

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Exhibit II: A graph displaying TIPS term structure allocation as of June 30, 2024

Our portfolios finished Q2 a few basis points ahead of the benchmark, bringing relative year-to-date performance to 23 basis points. The duration overweight contributed to performance while our yield curve position detracted a few basis points. As we begin the second half of 2024, we preserved the curve positioning and brought duration exposure closer to neutral.

Inflation and The Economy

After three consecutive upside surprises, Consumer Price Index (CPI) inflation moderated in Q2. Measured by annual changes in CPI, headline and core inflation are 3.0% and 3.3%. Core services excluding housing, the category also known as supercore inflation, decelerated the most. After a rapid increase in Q1, supercore was flat in May and June, bringing a deep sigh of relief to the Fed. (Exhibit III.)

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Exhibit III: A table showing inflation rates as of June 30, 2024.

Overall, core CPI inflation remains a shelter (or housing) story, not only because it represents over 40% of the index, but because the main categories in the shelter complex, rent and owner’s equivalent rent, continue to grow at a solid pace. Current rental costs, measured by Zillow or the New Tenant Repeat Rent published by the Bureau of Labor Statistics and the Federal Reserve Bank of Cleveland, show lower rent inflation, but since CPI shelter usually lags these indicators by several months, it may be early to take the recent drop in shelter inflation as the beginning of sustained improvements in housing inflation.

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Exhibit V: A chart displaying Federal Reserve financial conditions as of June
30, 2024.

Between March 2022 and July 2023, the Fed increased the policy rate 525 basis points. Inflation has come down, but it remains above the 2% target. To a large extent, benign financial conditions have made the proverbial last mile the most difficult to conquer. Consider the Fed’s Financial Conditions Index (Exhibit V); a blend of interest rates, corporate yields, home and equity prices, and the dollar; after its tightest level in December 2022, it turned negative in mid-2023, signaling tailwinds to economic growth. Under these conditions, the economy remained growing and may add some demand-driven upside inflationary risks.

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Exhibit IV: A graph showing contributions to Core CPI inflation as of June
30, 2024.

We cannot not rely on a navigation system to manage our portfolios either, but our expected returns framework and our investment process guide us through short-term uncertainties. As mentioned above, we see attractive opportunities in real yield curve positions as the current curve reverts to a more normal shape. In addition, inflation accruals above 3% while breakevens remain around 2.3% give TIPS and advantage over nominal Treasuries. It is a good time to invest in TIPS. Have a good summer!

Performance As of June 30, 2024
Composite/Benchmark	3 Mo.	YTD	1 Yr.	3 Yr.	5 Yr.	10 Yr.	Since Inception
BBH Inflation-Indexed Fixed Income Composite (Gross of Fees)	0.89%	0.91%	2.66%	-1.40%	2.04%	2.00%	5.03%
BBH Inflation-Indexed Fixed Income Composite (Net of Fees)	0.85%	0.84%	2.51%	-1.55%	1.88%	1.85%	4.87%
Bloomberg U.S. TIPS Index	0.79%	0.70%	2.71%	-1.33%	2.07%	1.91%	4.69%
Returns of less than one year are not annualized. The Inflation-Indexed Fixed Income Composite inception date is 04/01/1997. Sources: BBH & Co. and S&P Past performance does not guarantee future results.

¹ Basis points (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.

RISKS

The value of the portfolio can be affected by changes in interest rates, general market conditions and other political, social and economic developments. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.

Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, maturity, call and inflation risk; investments may be worth more or less than the original cost when redeemed. Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices.

Foreign investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards.

The Strategy may also invest in derivative instruments, investments whose values depend on the performance of the underlying security, assets, interest rate, index or currency and entail potentially higher volatility and risk of loss compared to traditional bond investments.

Holdings are subject to change. Totals may not sum due to rounding.

The Bloomberg U.S. TIPS Index includes all publicly issued, U.S. Treasury inflation-protected securities that have at least one year remaining to maturity, are rated investment grade, and have $250 million or more of outstanding face value. The index is not available for direct investment.

“Bloomberg®” and the Bloomberg indexes are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indexes (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Brown Brothers Harriman & Co (BBH). Bloomberg is not affiliated with BBH, and Bloomberg does not approve, endorse, review, or recommend the BBH Strategy.

Effective duration is a measure of the portfolio’s return sensitivity to changes in interest rates.

Credits: Obligations such as bonds, notes, loans, leases and other forms of indebtedness, except for Cash and Cash Equivalents, issued by obligors other than the U.S. Government and its agencies, totaled at the level of the ultimate obligor or guarantor of the Obligation.

Data presented is that of a single representative account (“Representative Account”) that invests in the strategy. It is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the Inflation-Indexed Fixed Income Strategy.

Brown Brothers Harriman Investment Management (“IM”), a division of Brown Brothers Harriman & Co (“BBH”), claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.

To receive additional information regarding IM, including a GIPS Composite Report for the strategy, contact John W. Ackler at 212 493-8247 or via email at john.ackler@bbh.com.

Gross of fee performance results for this composite do not reflect the deduction of investment advisory fees. Actual returns will be reduced by such fees. Net of fees performance results reflect the deduction of the maximum investment advisory fees. Returns include all dividends and interest, other income, realized and unrealized gain, are net of all brokerage commissions, execution costs, and without provision for federal or state income taxes. Results will vary among client accounts. Performance calculated in U.S. dollars.

The objective of our Inflation-Indexed Fixed Income Strategy is to deliver excellent returns in excess of industry benchmarks through market cycles. The Composite included all fully discretionary, fee-paying domestic accounts over $10 million with an emphasis on U.S. inflation indexed securities. May invest up to approximately 25% outside of U.S. inflation indexed securities, and a duration of approximately 7-9 years. Accounts that subsequently fall below $9.25 million are excluded from the Composite.

Brown Brothers Harriman & Co. (“BBH”) may be used to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2024. All rights reserved.

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IM-14953-2024-07-17 Exp. Date 10/31/2024