In late-March, we asked: Is the medicine working? By medicine we meant the massive injection of liquidity into the economy as a cure for fending off deflation and laying the groundwork for recovery. At the time, we were mildly encouraged, in part due to the rising inflation forecast as derived from the spread between the nominal and inflation-indexed 10-year Treasuries.
More than a month later, there’s still reason for optimism, perhaps more so, thanks to the so-called green shoots that suggest better days ahead. Yet the rate spread, which is to say the market’s inflation outlook, hasn’t changed much since late-March. The current forecast is for inflation of 1.4% for the next 10 years, just barely up from around 1.3% from the end of the first quarter. In both cases, that’s a healthy change from expecting flat pricing, as was the case at the end of 2008. Low inflation as far as the eye can see would be nice, but is that a reasonable expectation?

In the months ahead there’ll be a thin line between a healthy rise in inflation expectations and the potential for burdensome pricing pressures later on. Deflation is a hazard to be avoided for a number of reasons. Although we can’t quite shut the book on the danger, the odds look increasingly in favor of mild inflation for the foreseeable future, as the chart above suggests. Behind this reasoning is the growing sentiment that the recession is at or near a bottom. Is it time for the Fed to begin tightening? Or are the green shoots still too tentative?

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April was another solid month of recovery for the capital and commodity markets, building on March’s rise. There’s still a long way to go to repair the damage of September through February. Indeed, it’ll probably take years for all the asset classes to return to old highs. But for the moment, there’s reason to be optimistic, if only tenuously.

The big winner last month: REITs, which surged nearly 33%. Even so, this slice of the capital markets has been so heavily battered over the past year or so that even an extraordinary run does little to reverse the damage.
The lone loser in our horse race was inflation-indexed Treasuries, which slipped 1.9% in April, although for the year so far the asset class is up 3.6%. Otherwise, everything posted a gain. Our passive global market portfolio index climbed a robust 6.6% last month, an improvement on March’s roughly 5% advance. Year-to-date, GMPI is off by a fractional -0.5% vs. -1.4% for U.S. stocks, based on the Russell 3000.
It’s tempting to think that the danger’s passed. Not quite. As we explain in this soon-to-be-published May issue of The Beta Investment Report, strategic-minded investors should remain wary. Yes, expected returns look enticing. But there are still many economic and financial challenges ahead and no one should underestimate the potential for short-term volatility.
In short, these are productive days for designing and managing asset allocation, but you’ll have to work hard to generate and keep every basis point of risk premium from here on out. That starts with maintaining steely discipline. Last we checked, there are still no free lunches available.