2021 saw inflation arrive at the front door. With economic activity picking up again, stimuli in full force and global supply chains disrupted from the pandemic, investors are realising that our visitor might be here for a while. The question now is: how easy is it going to be to edge the unwelcome guest out the door, and what does it mean for asset allocation?
Central bank policy makers appear to have a higher tolerance for inflation than in previous cycles, even more so because of QE. They are taking their time as Covid has created a low base from which a jump in inflation is inevitable. Equally, economic support measures are being gradually withdrawn, which complicate the analysis. Supply chain disruption and shortages of everything, from HGV drivers to semiconductors, and an uneven pandemic exit between countries, point to a lengthy period of artificial and temporary inflation. However, there is a risk of being too complacent─ once inflation expectations become engrained they can be persistent. All this means, in the words of the Fed, it is “very difficult to say” how transitory the current surge in inflation is. While this is unhelpful in answering our question, it does suggest central banks will play a long game in a) unwinding QE b) raising rates and c) remain nervous about growth.
Coming back the question of how bad is inflation right now, global CPI is topping the high-water mark achieved pre and post the 2008 Global Financial Crisis. The only time it was consistently higher than now was in the 80s, when rates were in double digits in many economies. Pandemic policy responses have been highly correlated everywhere, so has been inflation outturn. Chart 1 illustrates this increase in correlation.
What are markets pricing in terms of the quantum and duration of inflation in this cycle?
Breakeven inflation rates help us to answer this question. For instance, UK 10-year gilts nominal yields minus UK 10-year inflation-linked gilt yields gives us a 10-year ‘breakeven’ of 3.95% (RPI rather than CPI). This implies an expected average inflation rate over that time of 3.95% if bonds are priced at risk-neutral fair value (right hand side of chart 3). Breakevens across developed countries (DM) are already near, or pressing past central bank target levels (2% in most DMs) and historical averages, even before Covid measures are removed.’
It is worth adding a note of caution when looking at breakevens. There is a massive mismatch between the supply of inflation linked bonds and the demand for them. Governments, and a few utilities, are the only suppliers of inflation product and demand from pension funds and others tends to outstrip that supply, even in swap markets. Inflation-linked bonds are also not typically a liquid product, which may mean that high breakevens are just a reflection of a surge in demand caused by the growing dominance of inflation as an ‘investment theme’.
Therefore, what does this tell us about interest rates and bond yields? Looking at breakeven inflation and inflation outturns suggests that central banks should be hiking rates to stem inflation and yet they remain cautious for reasons outlined earlier. With billions of QE still to be unwound, huge uncertainties about inflation and economic growth prospects, ‘term premium’ should be higher than the near record lows set in 2019. These considerations have been a driving force for curve steepening across DM rates markets and seem likely to remain so, well into 2022. However, the global economic recovery is likely to be marred with setbacks and will see different geographies moving at different paces. historically, the US has been a first mover in recovery scenarios and the 2-10yr curve below illustrates how this steepening is already well underway as investors attempt to get ahead of economic fundamentals.
If inflation is here for a while, what does it mean for investors?
If central banks decide to unwind QE by selling their long-dated government bonds (rather than letting them mature) as a policy tool to fight inflation, then this sector would be a rather unappealing area to be positioned in. While a steepening curve will mean more attractive rates in the longer term, it is unappealing for fixed income investors today. So, what are investors doing in response?
1. Some funds have added ‘steepeners’ to hedge. A steepener is typically a short-position in a long-dated swap and a long-position in a short-dated swap.
2. Recreate option 1) through asset allocation. In its most simple form, this involves shortening the duration of the portfolio by allocating into short-dated assets or funds. For example:
- FTSE World Government Bond 0-1 Year sub-Index (i.e. roll-downs from the WGBI) or the FTSE Global Treasury Bill 0-1 Year Index Series
- FTSE Emerging Markets Government Bond 0-1 Year Index
3. Lighten duration heavy portfolios by shifting into fixed income portfolios without any duration at all such as floating rate notes or leveraged loans.
- FTSE US Treasury Floating-Rate Note Index
4. Increase allocations to TIPs, linkers or inflation-linked bonds funds.
- FTSE World Inflation-Linked Securities Index (WorldILSI)
- FTSE Emerging Markets Inflation-Linked Securities Index (EMILSI)
5. Commodities and risk assets tend to be less at risk from inflation, but equities and real estate have a had a long bull run.
6. Within fixed income, high yield credit tends to have shorter duration and high carry making it attractive on a hold-to-maturity view. Also, the FTSE US Preference Share and Hybrid Index has a short maturity to first call and high yields.
This process has been going on for over a year. Uncertainty has made short-term money market investments more attractive for investors. Unsurprisingly, total net assets in money market funds grew 21.7% over the year ending December 2020—the highest increase in the last 5 years1.
Equally, Chart 5 illustrates how flows into dedicated inflation funds picked up as the worst of lockdown passed and optimism about a recovery and inflation increased. Also, inflation-linked gilts saw outflows in 2019 on the back of uncertainty over RPI reform.
The new WGBI 0-1 year index is an alternative to a money market allocation and Chart 6 below illustrates how short duration indexes are outperforming higher durations ones. In this case, we have compared the WGBI 0-1 year with the WGBI 10+ as we can see how the 10yr+ started to underperform after the worst of the Covid lockdown.
[1] Morningstar Inc., data as of December 31, 2020, Worldwide OE, MM & ETF ex FoF ex Feeder, Exclude Obsolete Funds, Global Broad Category Group: Money Market.
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Originally Posted on November 2, 2021 – Inflation, The Unwelcome House Guest: Here to Stay or Just Passing Through
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