Mind the Reality Gaps

Less is so often more. Take a simple metric, like the breakeven inflation rate. One glance and we can see that the market expects prices to be rising at a rate of 2% in five years’ time—in line with the Fed’s mandate. That’s a useful and somewhat sobering indicator to keep in mind amid the frenzied attention given to where inflation will be in the coming months and by how much the Fed will need to hike rates to manage it.

The breakeven rate—calculated by subtracting the yield of an inflation-protected bond from the yield of a nominal bond—helps markets gauge where inflation will be in the next five years. While it’s based on market expectations it would be unwise to disregard it. In fact, we would argue this kind of metric is much more useful to long-term investors than day-to-day speculation on data points. Will the U.S. inflation rate fall or uptick from last month’s reading—and what will this mean? Will the Fed raise rates by 75 basis points (0.75%) or 50 basis points at its next meeting?

Expending energy on short-term analysis won’t yield insight into the kind of macro landscape we can expect emerging markets companies to be operating in over three, five or 10 years. It does serve to illustrate, however, what we regard to be reality gaps permeating popular economic commentary and analysis at the moment.

Take the aforementioned inflation-reality gap. The level of scrutiny given to near-term movements in prices is entrenching assumptions that prices will keep rising or at least stay high. But that won’t necessarily be the case. Elevated prices are in place partly because of significant non-economic triggers: supply bottle necks resulting from the pandemic, fiscal stimulus enacted to induce recovery from the pandemic, and high commodity prices caused by the war in Ukraine. As some of these forces start to unwind, inflationary momentum will weaken.