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- Inflation is a challenge for duration components of bond portfolios
- Credit remains well supported in this environment
- Inflation markets are interesting – both as a buy and as a sell
This year, the global economy has started to recover strongly from the damaging effects of COVID-19, the global pandemic that ground economic activity to a halt because of various essential lockdowns. Governments and central banks worldwide took decisive and necessary action in the form of proactive fiscal policy and maintaining interest rates at very low, even zero and negative levels, to support spending and confidence.
A consequence of a global economy that is rebounding with such force is rising inflation. The drivers of prices include strong demand for commodities such as oil and gas pushing up energy prices, constraints and bottlenecks in supply chains, and generally higher spending on consumer goods/services as economies continue to unlock through 2021. Many people put on hold their spending and purchases last year (travel, hotels, real estate) and are now reviewing their plans. Meanwhile, US inflation has been forecast to be 4.2% this year, before easing to around 2.2% in 2022 and 2023. (Source: The Fed – September 22, 2021: FOMC Projections materials, accessible version (federalreserve.gov))
As growth picks up and interest rates remain accommodative, one area of the macroeconomy that is under scrutiny is labour markets. We are close to full employment in a number of economies and the so-called ‘quit rate’ – people voluntarily leaving their job – was at an all-time high at the end of August. We believe a very vibrant labour market will potentially result in higher wages and more sustained inflation.
Active in duration and credit
Despite rising inflation, central banks remain ultra-accommodative with interest rates close to zero. Indeed, another way of viewing the overall impact from low monetary policy is the so-called ‘shadow rate’. In the Fischer Black model, the shadow rate is what the nominal short-term rate would be if it were allowed to fall below zero. According to the Wu-Xia Shadow Federal Funds Rate, shadow interest rates in the US are negative and have been since the start of this year. Wu-Xia Shadow Federal Funds Rate – Federal Reserve Bank of Atlanta (atlantafed.org) So this means central banks are actually more accommodative than what nominal interest rates indicate.
In this environment, the corporate bond market remains well supported, in my view. Monetary policy needs a positive real rate. If inflation is at 2%, then policy rates should be at least that high. This is clearly not happening today as central banks are still trying to stimulate the economy. Core inflation is currently around 4%, while short-term rates are next to zero. This means there is still a long way to go before real rates can return in line with inflation. Even more if you look at the Wu-Xia Shadow Federal Funds Rate, which is currently close to -2%. As long as central banks lag inflation, credit markets should remain well supported, because in that environment default rates will likely remain low, in my opinion.
Within our strategy we have been shifting away from US dollar investment-grade corporate bonds mainly into European corporates as we find the latter more attractive. In particular, we focused our purchases on banks – they offer a wide range of opportunities, from highly-rated papers to high yielding subordinated bonds. Also, banks are tied to the economy, so tend to do well when economies improve.
From a duration perspective, we believe that the combination of monetary and fiscal stimulus could result in higher growth and higher inflation. This in turn will put pressure on government bonds, particularly longer-dated ones. Moreover, government bonds don’t offer a favourable risk-reward as rates are generally close to zero, therefore offering limited upside in their price. In this context we maintain a low duration positioning in our strategy compared to the wider market.
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For Investment Professionals, Institutional Investors and Professional Investors only. We are delighted to invite you to our flagship Bond Vigilantes Virtual Forum on Wednesday 24th November from 15:00 to 16:15 HKT/SGT. You will hear from the Bond Vigilantes team who will provide their latest thoughts on fixed income markets and the wider economy, including their outlook for inflation and global interest rate policy.
Positioning in light of a reflationary environment
As we respond to changes in inflation and interest rate expectations, we believe it helps to be active and flexible in our duration and credit views to support active return generation, as explained above. However, there are some other tools we can use within the unconstrained approach of our strategy that give us the freedom to move between different fixed income asset classes (investment grade, government bonds and high yield), and even into equities (a maximum of 20% of total assets). Over the past few months we have favoured equities issued by companies operating in cyclical sectors, which traditionally benefit from an improving economy. This includes consumer discretionary, energy and healthcare sectors.
We have also been active in inflation markets — buying or selling government bonds indexed to the inflation rate (index-linked bonds) as we try to gauge the path of inflation in the coming period. For example, last year we were active in buying long-dated US TIPS (Treasury Inflation-Protected Securities) as they were pricing in a very low inflationary environment. This was inconsistent with our view. This year we have focused more on Japanese and Eurozone linkers. The latter we reduced just recently as inflation in the eurozone has surprised to the upside and inflation expectations have risen significantly.
We have been involved too on the sell side of the inflation market: recently we initiated a short position in UK inflation, via the use of long-dated inflation swaps. We believe inflation will generally remain higher, but the UK market is already pricing in inflation above 4% over the next 10 years — so market expectations are overdone, in our view. We think 4%+ will prove a challenge, particularly as the RPI (Retail Prices Index) measure of inflation is expected to be revised down due to the pre-announced reform of the index, due in 2030. So while we believe that inflation is here to stay, we also think in some cases it cannot get above a certain level and sometimes market expectations are off the mark.
We maintain a positive outlook for economic growth for the rest of 2021 and into 2022. But a consequence of this strong growth and robust employment data is creeping inflation, and we believe it will end up being higher than what we have been used to in the past — and more permanent. In this case, we are wary of holding too much duration because the prices of government bonds will steadily worsen as their yields rise in response to inflationary pressures.
We have also remained cautious on getting caught up in overvalued corporate bond markets, although we continue to look for attractive opportunities, particularly in Europe and UK markets and in sectors such as financials. As mentioned, we believe banks are like the mirror of an economy: when the economy is strong, banks are well-supported, while when the economy weakens, banks will suffer. We currently are in a positive macroeconomic environment, hence we like to own banks.
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