Falling oil and rising tariffs: The new year could prove challenging for inflation

The past three years have seen inflation rates move closer to central banks’ targets, helping to lift inflation breakevens and leave deflation fears firmly behind us.

Core inflation has proved more troublesome. Despite robust economic expansion, core inflation growth has been modest over the past few years. However, with oil prices falling, we anticipate that core inflation should prove to be more relevant in the new year.

What do we expect to see in 2019?

With the new year comes new challenges. This year we are expecting to see a convergence of headline and core inflation as oil prices fall and geopolitical risks continue to haunt markets.

Since 2016, surging oil prices have been pushing headline inflation above core inflation. However, as oil prices begin to tumble, so too does headline inflation. We anticipate that US inflation could fall to 1.5% in the summer of 2019 before rebounding to around 2%* towards the end of the year, and, while this is expected to be short term, this fall could have a negative effect on market sentiment.

Headline inflation may fall, but core inflation looks set to rise. The trade war is now a reality and as a consequence of import duties, core inflation in the US is predicted to rise by 0.2 – 0.5%*. While this is expected to be a one-off, we are getting closer to the end of the economic cycle, and historically, this has resulted in higher inflation, which could result in further risks emerging.

Inflation linked bonds vs inflation breakevens

As economic growth slows down we believe inflation-linked bonds are more attractive than inflation breakevens and the best way to take advantage of this is to overweight longer maturity inflation-linked bonds.

Inflation is expected to remain higher than the current level of inflation breakevens, providing investors with income that should be greater than nominal government bonds. This, coupled with slower economic growth, could push real yields lower, providing some potential for capital gains.

Where are we seeing opportunities in 2019?

We believe that while 2019 is set to be an interesting year for markets and inflation, there are still opportunities to be found.

The Federal Reserve (Fed) has been steadily hiking interest rates since 2015, and, with the Fed anticipated to pause further hikes in 2019, we believe that US TIPS have the most potential among mature economies. Going into 2019, we are overweight US TIPS across our portfolios.

In the euro area we have a preference for inflation-linked bunds. Despite their current very low yield level, the disappointing growth numbers across the single currency bloc should continue to make them preferable to other higher yielding alternatives. Especially in light of the European Central Bank ending quantitative easing.

Finally, politics is likely to continue to play a significant role in the markets this year, with Brexit likely to attract the lion’s share of the attention. We find UK inflation breakevens are too expensive as investors have been adding long inflation breakevens as a hard Brexit hedge. Our analysis shows that while the British pound has been relatively stable recently in comparison, the premium in the inflation market is comparable to what was priced-in after the referendum in 2016.

*Source: AXA IM as at 30.11.2018

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