How different inflation paths may impact inflation strategies
- Inflation still dominating the headlines
- Investors should consider how different inflation paths might impact their inflation strategies
- Short Duration still attractive but could now be the time to also consider all maturities?
It has been a summer of two stories: For Europe an energy crisis and concerns of an economic slowdown have dominated the headlines, while for the US, the market rally and consumer confidence suggests an expectation of a soft landing. Either way, when inflation might peak should continue to be a hot debate into the end of the year - and investors may need to consider how their inflation strategy may need to adapt to these changing market conditions.
There are a couple of scenarios likely to play out over the rest of the year and into 2023: Slowing growth and increasing inflation (stagflation) or slowing growth with inflation falling while still remaining high (disinflation).
Will growth slow?
Although US retailer Walmart reported in August that households’ spending had increased1 , this optimism isn’t reflected across the board. In July, core inflation in the US was still far above the Federal Reserve’s (Fed) target of 2% and the services component of the US Purchasing Managers’ Index contracted to below expansion threshold level. In the Euro Area, the decline was led by manufacturing while in China, the economic recovery from COVID-19 lockdowns is still taking place. Alongside this, Eurozone inflation rose to a record 8.9% in July and UK inflation level reached 10.1%.
The US was a beacon of hope for optimists with headline inflation coming off a little from its high last seen in November 1981. However, even with this slightly lower number for the US, there is no certainty over the speed of the inflation deceleration and the situation looks to be similar to last year at the same time when some were calling inflation “transitory” and suggested that it had peaked in July 2021.
Against this backdrop, it is perhaps not surprising that real yields are at levels last seen when the world was worried about deflation (2010 when the Fed expected inflation of 1% or less, 2014-15 when slow growth rates across markets triggered fears of deflation, 2018 when prices fell by over 1% compared the same month the previous year).
A stagflation environment
Stagflation, which occurs when there is persistent high inflation but also high unemployment and little consumer demand, is a scenario that many economists are projecting in their outlook. This is because the high and persistent inflation we have seen will impact purchasing power and consumer confidence, while the pressure on food and energy prices could mean high inflation, despite reduced consumer spending, would be likely to remain.
In this scenario, central banks’ appetite to increase rates may be muted for fear of causing increased pain to householders. However, as was shown with the surprise 50 basis points (bps) interest rate hike from the European Central Bank on 21 July, we may not be through with interest rate uncertainty. This is why there is still a strong argument for short duration strategies, with their sensitivities more aligned to inflation rather than interest rates.
Breakevens, which performed well earlier in the year, may not perform as well going forward because, even while inflation continues to increase, the pace has slowed from earlier in 2022. As breakevens tend to follow inflation expectations they may, therefore, not perform as well as other strategies potentially could in this stagflation scenario.
If inflation rates begin to fall
Despite some indications of a soft landing in the US, there is little evidence at the moment to think that inflation levels will fall quickly any time soon. The long-held view that this is transitory is being challenged due to the stickiness of inflation and the underlying factors contributing to it. Even if it did start to ebb, the Fed’s slow response to the inflationary environment suggests it wouldn’t be able to make a quick about-turn. If inflation did fall but remained high, there would be pressure on central banks to balance the need for rate rises against the concern that if recessions become realities, there would be lessening appetite for higher interest rates amongst a hard-pressed public.
All of this suggests that maintaining a short duration strategy could continue to be a preferred strategy for some investors as inflation indexation should remain generous and there is uncertainty as to what central banks will do.
Having said that, if central banks engineer a recession, as some believe they will have to, in order to get inflation under control, there may be value to be found in long term inflation linked bonds. If at some point annual inflation rates eventually slow, monthly inflation numbers may remain elevated especially in the Euro Area and the UK. Therefore, all maturities inflation linked bonds €-hedged may enjoy income over 5% over the coming year due to the higher yields currently seen (they are currently trading close to 4.5%).2
For investors willing to accept a little more potential volatility, all maturities inflation-linked bonds may be an interesting option against this backdrop
Along with the type of strategy, investors should also think about how they achieve this exposure. Across the globe the inflationary environment is very different and the outcomes may be as well: US inflation is driven largely by overheating within the economy as opposed to a country such as Germany that is impacted more by food and energy price increases. Likewise, the expectations for rate hikes in the UK is much greater than in Japan. The global nature of supply chains means that an individual country’s domestic factors may impact beyond their local market. This is why taking a global perspective on inflation investing is important.
The signs all suggest that we are facing a recessionary environment but whether it translates into a disinflation or stagflation scenario is yet to be seen, and may vary by country. At the moment, we believe that real yields are in the “buy zone” although short duration inflation-linked bonds will probably see real yields stay in this category longer. For investors better able to weather the volatility, long duration inflation linked bonds might be more of a ‘buy and hold’ investment case.