Inflation: Time for linkers?

Inflation expectations are low but inflation-protected bonds should outperform their nominal peers.

After being a major concern of governments and central banks for decades, the fear of rising inflation has disappeared in developed markets - at least in the short term. In recent years, inflation has consistently undershot central banks’ targets and some investors fear that the deflationary stagnation that has plagued Japan for years will spread to other developed economies, pushing inflation expectations still lower.

Against this background, it may seem difficult to believe that inflation-linked securities represent a promising investment. However, for those with an open mind, it is worth considering the arguments for inflation-linked bonds. We principally see opportunities in the US and euro zone.

Energy price falls subdue inflation

Let’s first look at the drivers for the recent falls in inflation expectations. Despite the best efforts of central banks, spot inflation and inflation expectations have remained under pressure. In particular, spot inflation has been driven downwards by falling energy prices over the past year and a half. Since the second half of 2014, we have seen a marked downturn in oil prices, making energy a negative contributor to inflation. In Japan, the impact is less marked due to the April 2014 VAT hike and the large currency depreciation, with the energy contribution to inflation only turning negative this year. The contribution of the energy component to the major inflation markets is shown above.

Amid this energy-related fall in inflation, the performance of global developed inflation-linked bonds has suffered over the past two years in relative terms (see table below). In 2015, growth concerns related to China and emerging markets were an extra negative factor, stifling inflation expectations. Underperformance of index-linked bonds was most marked in the US, followed by Japan. UK and Euro linker markets have recovered a little over recent weeks, and now show flat or small positive returns for the year to date, whereas the US and Japan are still in negative territory.

Central banks drive expectations upwards

The question now is whether inflation expectations can move towards the central banks’ 2% inflation target and how quickly. Despite central banks’ extraordinary monetary policies of recent years and the ballooning of their balance sheets, insufficient inflation has been generated to meet their targets. US (core PCE) and euro zone inflation have missed their respective central bank targets for more than 30 consecutive months. In Japan, the target has been missed for most of the past decade. Going forward monetary efforts needed by global central banks will diverge.

In the US, we expect core inflation to gradually accelerate to 1.7% in 2016 and get close to 2% in 2017 which should facilitate their policy adjustment. We are at the beginning of the Fed’s normalization campaign of interest rates. Its monetary policy adjustment should also be supported by an improving economic cycle. A further upturn in the US dollar could, however, temper the pace of normalization.

In the euro zone, inflation is likely to recover gradually in the coming months. In the short term, base effects related to the oil price decline over the last months of 2014 should push inflation back up towards 1% in the coming months (from October’s 0% level). Afterwards, the increase in headline inflation is likely to be slower given that base effects were negative in the Spring and Summer, while core inflation is expected to remain close to 1%. Therefore, further monetary efforts – such as the expansion of QE and deposit rate cuts - by the ECB will be necessary to increase inflation and inflation expectations. A further depreciation of the euro could, however, facilitate their task.

In the UK, inflation is currently low, but should be buoyed at the turn of the year by base effects relating to the sharp fall in oil prices in late 2014. Cost pressures from higher wage growth in the face of a tightening labour market environment and reduced drag from sterling appreciation should take UK inflation to around 2% by the end of 2017. With domestic inflation pressures rising, the BoE could start hiking in Q2 2016, depending on global dynamics and the Fed.

Finally, in Japan, inflation is likely to remain subdued. Despite some acceleration in growth driven by consumer spending, inflation pressures should remain contained. A further rise in food prices is also hard to envisage. The Bank of Japan’s monetary policy is therefore expected to remain tilted towards more easing.

Inflation-linked investment opportunities

As economic performance improves in the UK and US and as the European Central Bank reinvigorates its QE programme, inflation-linked products could be beneficiaries. Our inflation valuation tools¹ , point to investment opportunities in both the US and the euro zone. The valuation signal for the UK and Japan, however, is negative. The break-even inflation valuation dynamics for the global linker market are illustrated below (see chart : “Inflation-linked bonds valuation”).

While Treasuries look slightly expensive, Treasury Inflation-Protected Securities (TIPS) seem more reasonably priced amid the current low inflation environment. We think US inflation should progressively turn upwards, driven by economic dynamics and base effects. Over the past year there has been a marked improvement in the employment market, while growth dynamics remain sound. Together with a Fed that seems to have integrated new drivers into its thinking – prospects for global growth, for instance - there is a risk of it reacting late and slow to inflationary pressures. This should create an environment in which TIPS outperform their nominal peers.

Looking to current market valuation, limited inflation pressures are discounted for the years ahead. With less than 1.4% of inflation priced in for the next two years, expectations are clearly below our own forecasts (see chart “US inflation pricing dynamics”). In a scenario where oil prices will gradually rise to $65 in 2016 and average these levels in 2017, inflation should stand at 2.1% in 2016 and 2017, strengthening our call for US inflation-protected assets.

Next to US TIPS, European linkers should also produce good returns versus their nominal peers. Base effects will be supportive, while the ECB will have to enhance its QE programme to counter the risk of inflation remaining below its 2% target for too long. In addition, carry dynamics, a sustained economic improvement and strengthening of the US dollar all bode well for the relative performance of inflation-linked investments.

We remain more prudent on the prospects for UK and Japanese linkers. Our valuation tools continue to point to the relative expensiveness of those markets versus their nominal peers and versus US and Euro linkers.

Linkers a good relative bet

While it may be a leap of faith for many investors to recalibrate their bond positions in favour of inflation-linked instruments, they are likely to be rewarded for doing so. Inflation expectations remain low in global linker markets. Global central bank policies (further expansion in euro zone or cautious adjustment in US and UK) should help to drive inflation expectations upwards. Certainly in the US and euro zone we see opportunities for investors to adjust their nominal exposure towards linkers.

Nicolas Forest, Global Head of Fixed Income Management

Sylvain De Bus, Senior Fund Manager - Global Bonds

⁽¹⁾Our break-even inflation valuation tools for global inflation markets are based on the following five indicators: BEI momentum, risk appetite, inflation momentum, monetary cycle and economic cycle. A weekly signal allows to capture market behavior dynamically.