With developed market inflation looking set to rise in the coming months, investors would do well to understand the implications for their portfolios and to consider how best both to hedge against inflation and achieve greater diversification
The massive fiscal stimulus late in the economic cycle, escalating trade tensions and a narrowing output gap are prompting investors to think more about the risks of rising inflation. After a long period of disinflation, some investors may not be wholly aware of these risks, so their portfolios may be insufficiently prepared.
As well as offering the opportunity to incorporate or increase a hedge against rising inflation, inflation-linked bonds can also offer an effective source of diversification from traditional stocks and bonds.
Cedric Scholtes, BNP Paribas Asset Management’s Head of Rates Committee & Co-Head of Inflation Team, gives his view on the current outlook for inflation.
Our framework for thinking about what drives breakeven valuations is to analyse their components, namely (i) expected inflation, (ii) inflation risk premiums, and (iii) liquidity premiums.
When we consider the expected inflation component, our view is that core inflation is slowly recovering as transitory factors fall out of the 12-month comparison, while hurricane effects will support categories like shelter and vehicle prices for annual inflation.
Commodity prices should remain supported by relatively strong global growth and reduced energy inventories.
At the same time, however, a relatively flat Phillips curve will prevent wages from accelerating sharply higher. Recent improvements in medical inflation bear watching given the longer-term structural story.
We thus envisage a very slow pace of recovery for core inflation over the next two years. All this has been supportive for spot BEIs, particularly at shorter maturities.
Inflation risk premiums are driven by the swings in investor risk aversion around the inflation theme. With President Trump promising to borrow and spend money as if it were going out of fashion – despite the economy already being close to full employment – and also threatening to start trade wars, there has naturally been considerable interest in Treaury Inflation-Protected Securities (TIPS) by investors looking to hedge inflation risks. Inflows into the asset class and strength in fuel prices have certainly been supportive for BEIs, although inflows do appear to have slowed somewhat in the last few weeks.
The inflation risk premium consideration also requires us to assess possible developments in the central bank’s reaction function. One upside risk for BEIs is that the Fed’s monetary policy framework could become more permissive towards inflation. Indeed, some Federal Open Market Committee (FOMC) participants, as well as former Fed Chairman Bernanke, have in recent months discussed whether the FOMC should, in extreme circumstances, pre-emptively commit to price-level targeting to more forcefully deliver on the FOMC’s price stability objective. President Williams of the San Francisco Fed, who was recently chosen to take over the New York Fed and the role of Vice-Chair of the FOMC, has also supported this idea. As new Fed Chair Powell settles into his role, it is highly likely that a review of the monetary policy framework will be announced in due course.
We must be cautious not to over interpret these (preliminary) discussions, however. After all, we have been led astray in the past by former Fed Chair Yellen’s talk of tolerating ‘inflation overshoots’ and her insistence on the ‘symmetry’ of the inflation target, only to see the FOMC raise the policy rate. Resetting the formal Personal Consumption Expenditures (PCE) inflation target from 2.0% to 2.5% or 3.0%, or adopting a price-path targeting framework, would necessarily imply a much looser stance on monetary policy, which might invite a further acceleration in risk sentiment that could in turn exacerbate financial stability risks. From a positioning perspective, it would invite establishing very large TIPS duration and BEI overweight positions. But at this juncture, we think this remains a largely academic discussion focused on developing options for the next recession, and not a theme with immediate market implications.
With 10-year Treasury yields reaching 3.1% recently, 10-year BEIs have continued their rise and are now testing 2.20%. It seems likely that they will break higher, perhaps to above 2.25%, as headline inflation moves higher over the coming months (due mostly to base effects).
Exhibit 1: US 10-year breakeven inflation rates continue to rise from their lows last summer
Source: BNP Paribas Asset Management, Bloomberg as of 17/05/18.
In the US, we anticipate core inflation pressures to build incrementally in the coming months, taking the year-over-year rate above the Fed’s 2.0% PCE target. Evidence of wage gains, along with rising energy, shelter and medical care prices, make us constructive on BEI. At the same time, growth is set to strengthen in the second half of 2018, as the impact of the fiscal stimulus begins to be felt, and amid still-loose financial conditions. As a result, we anticipate that the FOMC will proceed with rate normalisation as the Fed looks to offset the fiscal impulse. Simultaneously, the ramp-up in Treasury supply should put some upward pressure on real and nominal Treasury yields across the maturity structure.
In the eurozone, the recent weakness in economic data and downside surprises in inflation prints suggest that the ECB’s rhetoric will likely remain accommodative, and that no major decision will be made for quantitative easing (QE) tapering in the very near term. Given this backdrop, and barring a major worsening in Italy’s political situation, peripheral bonds will likely continue to do well. And while preliminary April core Harmonised Index of Consumer Prices (HICP) revisited recent lows and printed at 0.7%, the weakness can largely be attributed to distortions in packaged holiday prices caused by the timing of Easter holidays.
We expect core inflation to rebound to around 1% in the coming months and resume its upward trajectory, albeit at a very gradual and limited pace. Given the favourable inflation carry in the coming months and with large linker supply mostly out of the way, we favour a modest tactical long position in BEI.
In the UK, after having spent the last nine months warning the market about the need for policy rate normalisation as the UK’s economic slack has more or less been eliminated, recent soft economic data has given the Bank of England (BoE) pause for thought. The strengthening trend in the British pound since mid-2017 is now put into question, and the BoE did not hike rates in May.
This sudden change in policy expectations led us to reassess our short BEI bias and reinforced our preference to be nimbly tactical in our UK positioning. In the next couple of months, we see the limited supply in index-linked Gilts and a return of pension hedging activities as favourable to long-dated real yields, both relative to shorter-dated linkers and conventional Gilts.