Falling Rent Is Cooling Inflation Making VGLT A Buy (VGLT) (2024)

Introduction

Many previously inflationary forces are now turning deflationary. This means Vanguard Long Term Bond ETF (NASDAQ:VGLT) should partially recover from a poor 2022, being driven primary by inflationary expectations.

The main components of this cooling are:

• Rents are falling fast with a 0.4% month-on-month decline in November.

• Transport costs have fallen substantially in the last 6 months.

• Car gas prices have returned to pre-war levels of around $3 a gallon.

This report will discuss these elements further as well as consider the main risk and also why VGLT is a good portfolio allocation and recession hedge.

We have a price target for VGLT of $78 per share.

Before we consider the deflationary forces at work, let's first be clear as to what the VGLT ETF actually is, as well as the context for long-term bond ETFs.

Intro to the Vanguard Long Term Bond ETF

VGLT holds long term US government treasuries. It tracks a market-weighted Treasury bond index for bonds that are 10+ years. It does this via buying a sample of bonds with a range of maturities and risk profiles to track the index.

VGLT is quite similar to the iShares 20+ Year Treasury Bond ETF (TLT) although smaller. Assets are around USD4bn compared to TLT's USD28bn. VGLT is the lower fee option of 0.04% versus TLT's 0.15% p.a. For fixed income holdings fees are very important and thus we prefer VGLT.

2022 was a bad year for VGLT alongside other long term bond ETFs, falling 31.09% for the calendar year. This was a result of rising interest rates and rising inflationary expectations.

In 2022 the CPI spiked by mid-year to turn negative by year end.

The higher levels of inflation of 2022 have, however, crushed long term bonds.

2023: The Return of the Bond Bull Market?

First, let's provide some context to the great bond sell-off of 2022. It was the year the long bull market broke its long term trend. See below.

Whether this bull market will resume is a matter of some contention.

Should the following deflationary impacts add up as we expect in 2023, then a return to the bond bull market is almost certain.

Deflation: Rents are falling in Real Time

Rents are the forgotten key to the Consumer Price Index - CPI, despite the focus of talking heads who love discussing energy prices.

Rent by contrast can seem boring, but housing costs are 42% of core CPI.

Even when you boil back housing costs, they remain the largest component at 32% of overall inflation. Where rent and housing go, so does CPI.

Yet for rents, the CPI surveys lag real time indices like Zillow's (Z).

It has been widely reported that CPI rental surveys lag real-time rent index calculations by as much as a year. Indeed, the Bureau of Labor Statistics, who are responsible for calculating the CPI are aware of the issue as this research paper from October 2022 on the topic shows.

Real time data, from Zillow shows rent are falling fast.

The November fall of 0.41% over October was the fastest amount in at least 7 years, and is clearly deflationary. Yet we won't see the CPI reflect this for several months or even quarters. Zillow found the biggest declines in these cities.

Rents are falling fastest month-over-month in Raleigh (-1.3%), Austin (-1.2%), Seattle (-1.1%), San Jose (-1.1%) and New York City (-1.0%). These are some of the most expensive rental markets, and include some of the biggest tech employment hubs in the country, an industry that has seen more than its share of layoffs this fall.

Why are rents falling?

Many believe falling household formation is the main cause, and that is likely true. Many are responding to higher rents by living in shared accommodation or higher costs by renting out a room. This is certainly the main impact in the short term.

Given rents have been the largest single source of inflation (see large bubble above), the early signs of deflation should give us great confidence that inflation is cooling fast and may even turn deflationary by year end.

Deflation: Container Costs fall back to earth

A big source of business cost pressure was the spike in the cost of shipping.

The cost of a 40 foot container from Shanghai to LA surged from around $2,000 to more than around $12,000 in September 2021.

This makes about an 80% fall from early 2022 back to prices which are similar to pre-COVID levels at least for LA. Shanghai to New York isn't yet back to pre-COVID levels, but based on the trend, should be soon.

This is a massive deflationary impact and allows businesses to slow price rises or pause them while rebuilding margins.

Diesel prices, one of the largest variable costs of freight on American soil, have also eased noticeably from highs near $6 per gallon in June and July 2022.

Price levels of $4.50/gallon are still elevated but over the course of 2023 the comparisons to 2022 will probably get much easier to beat.

This again helps company margins for goods buyers/distributors and reduces pressure to increase prices further in 2023. Speaking of fuel prices...

Deflation: US Gas Prices have eased

Another important deflationary impact is the price of gasoline.

$3/gallon levels are now similar to pre-Ukraine war levels. However the mid-year spike during 2022 will start making year-on-year comparisons much easier for the 2023 year.

Thus, like diesel fuel prices a deflationary impact is likely as we traverse 2023.

VGLT as a part of your overall asset allocation

Too many retail investors spend all their time on stock picking and almost no time on considering their overall asset allocation. By contrast, investment advisers start on this question and consider it the most important. "Asset Allocation" means, what percentage of your portfolio should be in stocks versus income-producing bonds, as well as real estate and alternative holdings.

Only once the asset allocation is decided would stock selection commence.

Most investors should hold at least some bonds with the proportion rising as an investor ages and passes into retirement and beyond. Here is a fairly typical retirement asset allocation from Charles Schwab below.

Is this, above, the right one for you? We have no clue, because you should discuss this with your adviser. It demands a personalized approach.

We DO think VGLT should form a small part of most portfolios in the income component for most investors in most years, with the possible exception of the very youngest and risk tolerant.

However we believe that 2023 presents a good chance for above average risk adjusted returns for VGLT for most investors.

VGLT is a Recession Hedge

Bond investments, particularly government treasury holdings like VGLT, are the stars of portfolios when recession strikes. They tend to make money while equity markets are falling. Well, in most years.

2022 of course as an outlier in this regard. It's on the far left below.

The chance that 2023 will be a repeat performance for bonds is never zero, but it is quite small.

An unexpected spike in inflation forced the US Federal Reserve to raise rates at the fastest pace in a generation or more. Interest rates and bond prices have a perfect inverse relationship. Our base case is that any slowdown will be mild.

Should the economy completely tank, then money will flow from equities to longer term bonds because weak demand will bring down inflation and inflation expectations.

Risks - Inflation doesn't fall

For VGLT everything hinges on inflation. To be more specific, it hinges on long term inflation expectations.

Should high inflation stubbornly remain, then there will likely be no gains in VGLT's market price. If inflation stays near 8-10% or above, then VGLT is likely to fall further in 2023. This seems unlikely, but let's briefly consider it.

How might that occur?

The main risk, in our opinion, is a massive oil price jump.

Given monetary tightening and weak residential rents, the only possible culprit would be a large oil supply interruption like the early 1970's.

Even then, given the smaller energy intensity of the economy and modest weighting of energy in the CPI, the oil price rise would have to be significant. By our back-of-the-envelope estimate, it would need to breach $150 per barrel of oil but more likely stay at $200+ a barrel to keep the CPI near 8-10%.

Nothing is impossible of course. Saudi Arabia or Russia both have the supply to create to this shortage. However, we believe both have reasons to avoid this disruption. Russia needs the money to fund weapons for war.

Saudi Arabia wants steady prices in the $90-100 per barrel range to be highly profitable, yet rebuild a reputation damaged by a political assignation at their consulate in Turkey. For example, Saudi Arabia has announced donations and investments of almost $10 billion in Pakistan for flood and debt relief. These activities should be read as influence building. If Saudi Arabia spiked the oil price it would undercut influence building in developing countries.

Only widespread disruption in multiple locations would equal disruption from these two large oil producers. The chance of that seems even further remote.

Conclusion

We have a firm view that inflation will decline rapidly in 2023. The deflationary impact of energy and in particular rent makes us confident the US Federal Reserve's 2% goal will be achieved and possibly undershot (aka deflation). This will return long term bond yields close to previous levels and produce good gains for long term bond holders.

VGLT has already begun to turn making good gains to start 2023 of about 4.1% when this report was submitted.

The beauty of buying VGLT is that it will perform well in a soft landing, but do even better should a significant recession occur in our view. It fits nicely as a small allocation of most portfolios but can add some alpha in 2023.

Thus VGLT is a buy at current prices with a price target of $78 a share with a gain of about 21% above current price levels.

CGP Asset Management manages discretionary trading accounts for clients in a “Global Technology Growth” strategy. This strategy combines quantitative and qualitative elements with a global perspective. The parent company Caterer Goodman Partners was co-founded by Owen Caterer in 2011 as a financial advisory firm, but since 2017 has focused exclusively on discretionary trading accounts on Interactive Brokers.