What does the current late economic cycle mean for inflation-linked bonds?
We believe the current late cycle economic conditions – slower growth and stable inflation – coupled with central banks’ accommodative shift since the beginning of 2019, is creating a positive environment for inflation-linked bonds. In our view, beyond the recent rally in oil prices, valuations are attractive, and inflation-linked bonds are an attractive vehicle to begin increasing portfolio durations from a cyclical perspective.
It’s late cycle, not recession
Over the past few months, incoming economic data (while recently reassuring) is confirming that the pace of economic expansion is slowing down. ISM numbers in the USA or PMIs across Europe are pointing to more moderate growth numbers. Some forecasters are worried about a recession as the spread between 3-Month US Treasury Bills & 10-Year Bonds (historically a reliable recession indicator) has been inverting. AXA Investment Managers (AXA IM) does not expect a recession as central banks have been very quick to switch from the normalisation of monetary policies to an accommodative stance again.
Late cycle means stable inflation
While it is generally understood that in a recession inflation should fall, the ever more accommodative central banks policies are likely to extend the cycle further. Late cycle economics suggests to us that while economic growth is slowing down it should remain positive and inflation should be expected to remain broadly stable.
Inflation remains a global phenomenon
A widespread misconception about inflation is that it is higher in the US compared to the Euro Area. It happens that core inflation, which is the economists’ preferred measurement of inflation – and is a measurement that excludes food and energy – is not calculated using the same methodology on both sides of the Atlantic.
In the US the largest share of core inflation is “shelter”: rents matter a lot in the USA when calculating inflation, while they are not considered in the Euro Area. Comparing like-for-like Euro Area and US core inflation would result in a gap of only 0.5% on average, meaning that beyond short-term divergences and statistical noise, the common trend in inflation remains very strong across advanced economies.
Our take is that, globally, inflation should remain broadly stable over the coming years and that short-term pessimism is likely overdone. Not to mention that oil prices are up sharply since the beginning of 2019 – back to where they were trading a year ago.
The market is quite pessimistic about the future of inflation
Our experience with the inflation-linked bond market is that while long-term trends in inflation are hard to predict, the market generally captures short-term inflation developments quite well. Still, inflation sentiment can weigh and this may create opportunities for investors.
One indicator that we like to look at, for a simple valuation assessment, is the spread between the market pricing of future inflation (also called inflation breakeven) and economists’ forecasts. We use the International Monetary Fund’s (IMF) forecasts for transparency and consistency reasons.
This indicator would show that the US and Euro Area inflation-linked bond markets are pricing-in less inflation for the year ahead than the IMF’s economists. The exception to this rule being the UK inflation-linked bond market which valuations are, in our opinion, too expensive due to a Brexit risk premium.
Where are we finding value?
The relatively low level of inflation breakevens compared to economists’ forecasts is a good sign to us that inflation-linked bonds are attractive from a valuation perspective. What this indicator suggests is that in the Euro Area and the US inflation-linked bond markets, investors can potentially earn an additional income from buying inflation-linked bonds instead of nominal government bonds.
What matters for investors is not so much the outright level of inflation but the spread between the actual rate of inflation and the level that trades in the market. In this regard the current situation presents a potential opportunity to take advantage of low inflation expectations, at the time that oil prices are rallying, as well as to potentially earn an additional income compared to government bonds for the same sovereign risk.
What does this mean for hedging?
A big debate in inflation-linked bonds investing is whether investors should keep or hedge the duration exposures that come with inflation-linked bonds.
We believe that in the current environment, where central banks are concentrated on propping up economic growth, monetary policies should remain accommodative for some time. Our preference goes for simply buying inflation-linked bonds and not hedging the duration in order to potentially benefit from the inflation indexation as well as the carry and roll-down effect.
What does a flat yield curve mean for duration?
From a cyclical perspective a flat yield curve has been a good signal to add duration to portfolios. We believe that adding duration with inflation-linked bonds is an attractive strategy that could help to hedge portfolios against central banks’ complacency and slower economic growth.
A flat US Treasuries curve: a “buy” signal for duration
Source: AXA IM, Datastream as at 09/04/2019
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