Exhibit I: A table displaying real yields and breakevens at five-, 10-, and 30-year internals for inflation indexed markets as of September 30, 2024.
3Q Highlights
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The Time Has Come
For fixed income investors, tracking expectations implied by futures markets is a favorite activity. This year fed funds futures priced anywhere from one to six rate cuts, but strong economic data kept the Federal Reserve (Fed) on the sidelines, leading some to suggest there would be no policy rate cuts in 2024. This changed at the Jackson Hole Economic Symposium in August, when Chair Powell practically announced a September cut, stating, “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
Labor market reports released early in Q3 2024 indicated that job growth fell short of expectations. Meanwhile, inflation continued its gradual approach toward the Fed’s 2% target. This led to a decline in 5- and 10-year maturity real yields of 64 and 51 basis points (bps)1, steepening the real yield curve between those tenors. Although market-implied inflation expectations (breakevens) fell during the quarter, year-to-date total returns on Treasury Inflation-Protected Securities (TIPS) remain 1% ahead of nominal Treasuries, illustrating the value of inflation accruals.
Throughout the year, the Fed’s data-dependent approach tied yield volatility to economic releases. At the beginning of 2024, investors in fed fund futures markets anticipated five rate cuts of 25 bps each by September. As data showed a healthy economy, investors adjusted their expectations to just one. Chair Powell’s speech at Jackson Hole, which expressed the Fed’s concerns about moderation in the labor market, made it clear that a cut was coming and sparked a debate over its magnitude. On September 18, the Fed lowered the funds rate by 50 bps. We do not believe this cut is directed at stimulating a weak economy, as growth remains stable. Instead, we believe the rate cuts will ease restraints on some consumers and businesses.
Portfolio Positioning and Performance
Our TIPS portfolios hold 10-15 securities selected from dozens in the Bloomberg U.S. Treasury Inflation-Linked Index. Compared to this benchmark, our positions emphasize short-maturity TIPS over intermediate ones. This curve structure seeks to capitalize on a steepening of the real yield curve, which inverted in 2022 when the Fed began its tightening cycle. In Exhibit II(a), note the divergence between the current real yield curve and the pre-pandemic average real yield curve. Currently, the slope of the 2- to 5-year segment of the real yield curve is -25 bps, which is 120 bps flatter than its long-term average. Considering valuations of current real yield levels, combined with the onset of an easing cycle, we have established a small duration overweight relative to the benchmark.
Exhibit II(a): A chart displaying individual TIPS allocations where there is a divergence between today’s real yield curve and a more normal pre-pandemic average real yield curve as of September 30, 2024.
Exhibit II(b): A chart displaying TIPS term structure allocations as of September 30, 2024, where one- to three-year and 15+ year durations have a positive contribution.
For the year, our portfolios are 15 bps ahead of their benchmarks. This quarter detracted a few basis points, primarily reflecting the real yield curve flattening early in Q3 while our portfolios are positioned for a steepening. The real yield curve steepened late in the quarter, and we expect the Fed’s downward pressure on short-maturity rates to further steepen the curve by year-end. As we enter Q4, we maintain our portfolio positions mostly unchanged.
The Economic Environment
In the quarter, inflation and employment remained at the forefront of economic discussions. Inflation, measured as the annual change in the headline Consumer Price Index (CPI), stands at 2.4%, while CPI excluding food and energy (core CPI) is at 3.3%. The annual change in Personal Consumption Expenditures excluding food and energy (core PCE), the Fed’s preferred measure of core inflation, is currently 2.7%. Inflation measures have been on a consistent downward trajectory in recent months. As in previous quarters, shelter services drove core CPI inflation this quarter. Core inflation increased at an average monthly rate of 0.25%, of which shelter added approximately 0.27%, while goods sector disinflation detracted 0.02%.
Exhibit III(a): A chart displaying the change in annual inflation as measured in the Headline CPI, Core CPI, and Core PCE as of September 30, 2024.
Exhibit III(b): A chart displaying annual contributions to Core CPI inflation by as of September 30, 2024, by sector: Shelter contributed, while goods detracted.
The Fed highlighted concerns about the labor market and shifted emphasis to employment, the other component of its dual mandate. It is important to note that the economy has added 1.8 million jobs thus far in 2024, averaging 200,000 jobs per month. A slowdown occurred during the summer months, when job openings and the quits rate—the rate at which workers leave their jobs for better opportunities — declined. Currently, job openings are around eight million, slightly above the pre-pandemic peak of 7.5 million but well below the 2022 peak of twelve million. The quits rate fell to 1.9% in August, aligning with its long-term average. These figures suggest a gradual cooling in hiring activity, not a rapid labor market deterioration.
Exhibit IV(a): A chart depicting labor market conditions by the monthly, three-month average, and 12-month average change in the nonfarm payroll as of September 30, 2024.
Exhibit IV(b): A chart depicting labor market conditions by the change in quits rate, which has declined as of September 30, 2024.
Conclusion
The Fed’s recent rate cut signals a cautious shift in monetary policy, highlighting its commitment to achieving a soft landing. Although the labor market is gradually cooling and inflation is approaching target levels, the Fed’s stance reflects a preemptive approach rather than a reaction to economic weakness. The decision to cut rates, even with stable growth, aims to mitigate potential risks and sustain economic stability. Nevertheless, September’s strong job market surprise serves as a reminder that financial conditions remain easy, continuing to provide tailwinds to economic growth and inflation. Moreover, fiscal deficits projected as far as the eye can see, protectionist trade policies, and an increasingly complex geopolitical scenario add further uncertainty to investment decisions. The time has also come to consider TIPS to enhance a portfolio’s protection against unanticipated inflation.
| Performance As of September 30, 2024 |
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|---|---|---|---|---|---|---|---|
Composite/Benchmark |
3 Mo. |
YTD |
1 Yr. |
3 Yr. |
5 Yr. |
10 Yr. |
Since Inception |
BBH Inflation-Indexed Fixed Income Composite (Gross of Fees) |
4.05% |
5.00% |
9.80% |
-0.58% |
2.55% |
2.61% |
5.13% |
BBH Inflation-Indexed Fixed Income Composite (Net of Fees) |
4.01% |
4.88% |
9.64% |
-0.73% |
2.40% |
2.45% |
4.97% |
Bloomberg U.S. TIPS Index |
4.12% |
4.85% |
9.79% |
-0.57% |
2.62% |
2.54% |
4.80% |
| 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. |
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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.
Not FDIC Insured No Bank Guarantee May Lose Money
IM-15430-2024-10-15 Exp. Date 01/31/2025
