By: PIMCO
Harvest Exchange
February 17, 2017

Encroaching Risks to Capital Preservation

Positive economic data continue apace in the U.S., from firming employment to renewed consumer spending. The latest news on inflation confirms the trend: The Consumer Price Index (CPI) showed inflation running at 2.5% year-over-year.

The data do not even tell the whole story: Also in play are the Trump administration’s growth-oriented fiscal stimulus and tax policies. Despite the long road from policy articulation to policy implementation, the Federal Reserve is eager not to be perceived to be “behind the curve,” as Fed Chair Janet Yellen recently reiterated the Fed’s commitment to continue on the path toward interest rate normalization.

As the signs of growth quietly mount, investors should prepare for the shift toward a rising rate environment by focusing on income and capital preservation.

Costly capital preservation

The costs of capital preservation have been rising for some time due to low interest rates. Investors using traditional cash liquidity management instruments such as money market funds may want to consider the ramifications of remaining in strategies that offer liquidity but little in income or return, especially in the face of rising rates.

Recent indicators also confirm that while contained (and perhaps benign) in a historical sense, inflation is clearly rising, presenting another potential cost for capital preservation investors. In addition to the increase in consumer prices, the latest Producer Price Index (PPI) posted an increase of 1.6% year-over-year. Similarly, major market indicators of inflation, breakeven rates in Treasury Inflation-Protected Securities (TIPS), have moved markedly higher in recent months. Chair Yellen even highlighted in her testimony to Congress on February 14th that she found it “reassuring” that breakeven expectations had risen even though they “remain low.”

With the Fed observing trends toward higher inflation, investors should become more aware too of these emerging factors. We urge investors focused on capital preservation to consider whether it makes sense for them to limit their exposure to the combination of low returns and creeping inflation during the Fed’s rate normalization process. The combination could potentially erode the purchasing power of a pure capital preservation portfolio, including traditional money market strategies, throughout 2017 and beyond. Instead, actively managing cash and short-term allocations may help maximize returns and thus aim to mitigate the impact of inflation on the purchasing power of invested capital.