Fixed Income: How to Invest in a Higher Inflation World
This is the first of a series of blogs in which we will analyze the main inflation drivers that investors should consider in 2017 and beyond, as well as investment opportunities to deal with higher inflation across fixed income, equity and multi asset.
The inflation outlook has rapidly changed in the last few months and headline inflation has started to pick-up in developed markets.
CPI Headline Inflation
Source: Bloomberg, as of March 7, 2017.
There are multiple reasons behind this new inflation outlook, which we have recently discussed in our paper Investing in the Era of Reflation.
However, in my view, the most impactful of these drivers is the paradigm shift from Central Bank dominance to a more proactive fiscal stance.
We are at a point where Central Banks are gradually stepping back from being the engine for potential growth/inflation and they are now leaving room for Governments to step in. By acknowledging the reduced effectiveness of marginal increases to the monetary base and the economic cost experience of negative interest rates, we think that Central Banks have averted what was a major concern for us over the last few years: the supremacy of their policies. With fiscal policies becoming stimulative in most developed markets, notably Donald Trump’s pledge for a strong fiscal boost, we expect a more favorable and balanced macro policy framework, which could bring higher inflation expectations and a gradual normalization of yield curves.
Moving away from a scenario of extremely low/close-to-zero inflation, or even deflation in Europe and Japan, to a more benign inflation outlook is changing the perspective for fixed income investors.
With interest rates so low, even a further pick-up in inflation would easily push bond returns into negative territory.
In the coming months, I believe, it will be crucial for investors to build fixed income portfolios that aim to be resilient in a rising inflation scenario.
On this respect, we believe investors should consider short duration bonds in their portfolios. In the US, we see more space for the medium part of the curve to cheapen, as investors could start to incorporate expectations for further rate hikes once the next one materializes. In the Eurozone, we expect some steepening of yield curves, as higher inflation expectations will gradually be incorporated in long-term yields. However, this trend will not be straight forward. Political risk and news flow will probably continue to dominate in the next few months, temporarily altering the shape of yield curves and requiring an active approach to curve movements. In the Eurozone, a key element to watch, in this respect, is the electoral cycle (especially the French elections); in the US it is Trump’s policy implementation; in UK it is the “how” and “when” of Brexit unfolding; and in Japan it is the effectiveness of Abe’s fiscal stimulus.
Another valuable option for fixed income investors may be inflation-linked bonds, which we consider to be a global opportunity for 2017. In a rising inflation environment, inflation-linked bonds can offer a hedge against inflation by compensating investors for higher inflation.
When we look at valuations, the market is still very conservative for near-term inflation projections. Short-dated inflation break-evens in the Eurozone offer cheap protection to further inflation upside, in our view. The market is not pricing in a return to 2% inflation for the next 30 years, underlining a full “Japanification” of the Eurozone term structure.
EU Break Even Inflation Swap Curve Versus ECB Target Inflation
Source: Bloomberg, as of March 7, 2017.
If we plot the European Inflation Swap Curve – which considers the inflation priced in by the swap market for each maturity – we observe a wide gap for short and medium-term maturities between what is priced in and the ECB’s target. We think there is value in this segment.
We also see opportunities in inflation break-evens in the US. We have already seen some domestic drivers for price increases; this could push inflation above 2%, which is currently the level of inflation discounted by the market for the next 10 years.
In conclusion, we believe that the new reflationary scenario will be more challenging for traditional fixed income. However, we still see opportunities for active bond investors, able to assess the evolution of this market scenario, and its risks, and take a dynamic approach in managing their portfolios. Yield curve steepening, short duration bonds and inflation-linked securities are our investment ideas for navigating this new landscape in 2017.
 Breakeven inflation is the difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-linked investment of similar maturity and credit quality.
 A long period of sluggish growth and low inflation as in Japan’s experience.
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Originally Published at: Fixed Income: How to Invest in a Higher Inflation World