21 JUN

2018

Fixed Income , Asset Class

How to deal with inflation fears

After 5 years of “lowflation” complacency and a persistent hunt for inflation revival that drove central banks to unprecedented QE intervention, inflation fears are finally returning across developed and emerging markets. US Consumer price Index is up by 2.8% in May from a year ago, the biggest advance since February 2017. Eurozone Flash Consumer Prices stood at 1.9% YoY in May, the highest print since 2013. Canada April inflation rose to 2.2% in April, the highest level since 2012.

Actually, almost all the underlying components of inflation are flashing red: close to 60% of the US CPI index has potential upside risks and the share for Europe is even higher, at 65%! The recent  sharp rise in oil prices has boosted near term inflation. But tight labor market, demography and protectionism will also add long-term upward pressures. The G7 unemployment rate has reached its lowest level for 30 years. Business surveys, in US but also in Europe, show that hiring plans are at  their highest levels since 2007. And the world is going through an unprecedented phenomenon in terms of demography. In Europe, the retired population represents a whopping 30% of the working age population - an increase of 34% over the last 20 years. While an ageing population decreases the growth potential, a sharp rise of the dependency ratio would have multiple effect on the demand side, particularly on the demand for health services.

While increasing commodity prices and the tightening of the labor market underscores a growing economy, the unwinding of globalization toward greater isolationism is a greater concern for future inflation trends. Mounting protectionism (Brexit, trade tariffs and rising populism) will further isolate economies. In such a situation, inflation becomes more of a local, rather than a global, feature.

Inflation is also the archenemy of bond investors. When inflation is rising more than expected, bond investors can lose money! This also has implications for monetary policy. Central banks’ primary objective is to control price stability by setting their federal fund rate. Monetary Policy normalisation is well underway as inflation is on track, and likely to move higher. The US Federal Reserve is reducing its balance sheet and pursuing its hiking cycle. The European Central Bank announced the end of their net asset purchases program for December The Bank of Canada has raised interest rates 3 times since July. Interest Rates are bound to continue climbing as  inflation is growing up worldwide.

In a context of growing inflation and monetary policy normalization, we have a preference at Candriam for short-end inflation linked bonds. Looking to the historical performance of 1-5 year inflation linked bonds, both in Europe and across global linker markets you can see that this maturity bucket offers a much higher proportion of inflation return and a lower proportion of interest rate return comparing it with the whole universe of linker bonds. Short-end linkers also work as a risk-mitigating asset for global balanced portfolios. Amongst developed linker markets, we currently see mainly opportunities in Europe, the US and Canada were we think not enough inflation is priced in by the market. In terms of country allocation in Europe we have a preference for French and Spanish linkers.