View from the bond market

Inflation has been low in this business cycle, despite massive central bank liquidity creation. However, maybe some of the classical factors that kept inflation low – unemployment, spare capacity and lack of both corporate pricing and wage power – are becoming less of a constraint. Actual inflation has moved higher, modestly. Labour markets are tight in some countries and wages are responding, modestly. It is still difficult to imagine that this expansion ends with a late cycle growth and inflation spurge that requires a big increase in interest rates. However, bond yields and returns are so low that in real terms they are very sensitive to only a modest increase in inflation. Considering the job that inflation-linked bonds can do for an investment portfolio seems opportune.

Boom and bust

A former UK Prime Minister and Chancellor of the Exchequer once famously claimed his government had ended the cycle of “boom and bust”. Unfortunately, the event that proved him wrong was the biggest bust the UK economy had experienced since the Great Depression. The downturn that affected the global economy in 2009 marked the last days of Brown’s government and laid to rest claims that enough had been done in the sphere of economic policy making to tame the economic cycle. Since then we have had waves of financial market regulation, fiscal crises and fiscal austerity, and massive purchases of financial assets by central banks in a series of attempts to stop the last crisis happening again and to restore the kind of economic confidence that characterised the decade between the mid-1990s and 2000s. No investors should be under the illusion that the “boom and bust” cycle has been abolished or that we won’t experience a recession again. Tempting as it is, after nearly ten years of unbroken economic growth in the United States, to think that this goldilocks economy can last forever, one must really start to plan for the next downturn and how that will impact on investment portfolios. Take note that it is becoming a rather consensus expectation that the US will experience a recession in 2020, Europe has plenty of structural vulnerabilities to weaker global growth or higher rates, China is struggling with a collapse in infrastructure investment and concerns about trade, emerging markets are seeing recessions in some countries, and the UK, according to the Bank of England governor, faces a particularly difficult time if there is a “hard Brexit”. The global economy is still growing, but the list of downside risks should not be ignored.

Late cycle splurges

Typically the end of the business cycle is marked by an acceleration of growth (coming from either renewed stimulus, a pick-up in capital spending or exuberant consumers running down savings), a spike in inflation as labour markets tighten, and an overshoot of monetary policy. I wanted to focus on the inflation part of that story. Over the last decade, especially since central banks resorted to quantitative easing (QE), there have been a large number of people expecting inflation to rise. I have been one of them and been wrong. In reality, inflation, like GDP growth, has been much lower in this expansion than in previous episodes. The demand shock that followed the credit crunch, globalisation and the ways in which technology have impacted on the demand for labour and on production and distribution models have all conspired to keep inflation down. Today there is little inflation priced into inflation-linked bond markets and consensus economic forecasts have inflation lower in 2019 than the expected outturn for this year in a large number of developed economies. The reduction in US inflation in August seemingly reinforces this expectation that inflation will remain low even if wages are at last starting to increase. We have got used to low inflation and those forecasters of higher inflation can rightly be accused of crying wolf. Why would anyone think inflation is going to spike higher when for the last few years it has been well behaved despite the gradual erosion of spare capacity in the global economy?


Without a classic end-of-cycle inflation spike leading to sharply higher interest rates, what will end the business cycle? It could be a trade war led collapse in confidence and equity valuations, or an intensification of the emerging market crisis that hits world trade and commodity prices. Or it could be that the Federal Reserve’s (Fed) gradual interest rate increases become sufficient to slow the housing market, consumer spending and credit growth at some point over the next two years. But should we discount the inflation option? There are things happening that we should consider in terms of the inflation outlook. One is that inflation itself is higher this year than for the last three years and that, in some countries, it is already above central bank targets. Yes, the August consumer prices number in the US was softer than expected, but inflation has generally been drifting higher in the US for the last two years. It’s not an inflation boom and the levels of the inflation rate remain quite low, but the momentum has definitely been towards higher inflation rates.

Pay rises?

Looking deeper into what might cause inflation to spike higher we should start with the labour market. The US unemployment rate has been below estimates of the natural rate of unemployment for over a year now. In the past, these episodes of labour market tightness have led to higher wages. This seems to be happening now. Average earnings growth is picking up across a number of countries and reached 2.8% y/y in the US in August. The Phillips Curve might not be very well defined in reality but lower unemployment rates in almost all developed economies are starting to be associated with some increase in nominal (and real) wages. Demand for labour is strong and labour is in a better position for some time to push for increases in real incomes, something that politically has been an underlying factor in voter dissatisfaction. In some countries curbs on immigration have also had an impact on the supply and demand balance for workers, particularly at lower incomes. How much this, so far modest, increase in wage growth feeds back into prices remains to be seen. Companies are cash-rich but it is not clear how willing they are to divert that cash into higher compensation for employees or pass on higher wages to prices to retain healthy margins. At any rate, it is worth watching the wages numbers especially in the US where there is little sign of the labour market weakening. Just this week we had another decline in the weekly claims for unemployment insurance and the level of continuing claims is at a record low. There is also political pressure to raise wages in ‘gig economy’ type jobs, though these are limited in number.

Oil and trade

If you are looking for signs of potentially higher inflation, where else would you look? Oil is always a source of volatility in global inflation data and the oil price has been steadily rising all year. Brent crude currently trades at a spot price of $78/barrel, just shy of 50% above its level a year ago. Oil price volatility has less impact on consumer price inflation these days than it did in the past, but the magnitude of the increase in prices will have some impact on domestic energy costs, transport and travel.  We may also want to consider the impact of populist economic policies. The US has engineered a large fiscal boost which some estimates think adds 1% to GDP growth this year and next. Italy wants to relax its fiscal policy. Mario Draghi mentioned, in his most recent press conference, that fiscal strings were being loosened in Europe more generally. The UK has probably passed its peak level of austerity. This is all good for growth but comes when labour market conditions are tight in a number of economies. Protectionism and immigration control could also impact on prices and wages. If more tariffs are introduced on a broader range of goods, including consumer goods, it will raise prices (I think it will also be bad for growth and could be a significant trigger for risk-off in markets).  It’s hard to discern the impact of the tariffs introduced so far but it is worth noting that US import prices have been rising steadily despite a strong dollar. Import price inflation was 4.8% in July. In the depths of the commodity crash in 2015 the import price inflation number was -12%. 


Just as an aside, I looked at the latest UK labour market report. Vacancies continue to rise and hit a level of 833,000 in August, pushing up the vacancy to employee ratio. The distribution of vacancies by sector is interesting, with wholesale and retail trade and human health and social work activities accounting for one third of all vacancies in the UK. There have been anecdotes about shortages of staff in the National Health Service, and there are concerns generally about immigration policy and Brexit contributing further to these shortages. Addressing these shortages has both a fiscal and inflationary impact, although it is not clear that politically the will is there at the moment. However, it is a further sign of labour shortages which could ultimately have some impact on aggregate wage inflation.

Skinny in real terms

I’ve learned not to call for an imminent inflationary surge. The extent of the impact of a massive balance sheet recession on inflationary dynamics has become clear over recent years and even the great monetary expansion of QE has done little to offset deflationary forces. Until now, perhaps. Slowly the expansion has used up spare capacity. Slowly real wage growth is starting to reflect the tightness of labour markets. Policy led disruptions to the free flow of goods and labour might also generate a supply side effect on inflation if populism goes unchecked. When bond yields are still low (2.5% to 3.5% in the US, -1% to 2% in Europe), even modest increases in inflation are important in determining expected real returns. Real returns to financial assets were boosted in the 1980s and 1990s because inflation kept on falling. A reverse of that is not likely but we are starting from very low levels of real yield in fixed income. A modest increase in inflation will hit most fixed income returns in real terms. 

Look at linkers

Economic consensus forecasts and break-evens in the inflation-linked bond market are not pointing to any increase in inflation. However, I like inflation-linked bonds and, as I have always said, they deserve a place in any multi-strategy or multi-asset portfolio. At the moment they have two attractive characteristics. One is that they could outperform conventional government bonds if we do see inflation rise given the potential for break-even inflation rates to move to the top of their trading ranges on any further upside wage prints. Secondly, they are good risk diversifiers with the total return performance of
inflation-linked bonds having a negative correlation with the performance of equity and high beta credit like high yield and emerging markets. That hedging quality comes from the duration of the asset class, while the ability to beat conventional bonds comes from the inflation link and the accrual that provides relative to nominal yields. If we are in for an end of cycle rise in inflation and deterioration in risk asset performance, linkers should perform relatively well in terms of capital preservation.

Turkey bounce good for EM

Last word on emerging markets, where inflation is always something to consider. The Central Bank of Turkey raised the one-week repo rate to 24% this week, a one-off increase of 6.25 percentage points. The Turkish lira rallied and has managed to hold on to its gains so far. Turkish bonds have also responded well, with the long end of the market seeing yields tumble as much as 100 basis points (bps) – Turkey 5.75% 2047 bonds traded up in price from 73 to 80 in the wake of the monetary policy announcement. This positive response impacted on the entire emerging market asset class, with the most watched index of hard currency debt up 44bps compared to this time last week and now showing almost 0.9% return over the last three months. All the return has come from carry which illustrates how the asset class has become more attractive with a yield to maturity of 6.58%. Turkey is far from out of the woods, but decisive action by the central bank (the rate increase was more than expected and came only hours after President Erdogan had called for lower rates) should help stabilise the currency and prevent inflationary expectations from running away. Now all eyes are on a medium-term plan for structural reform. If there is some better news on the prospects of a US-China agreement on tariffs, emerging markets could well be the best performing fixed income sector in the remainder of the year.                   

All data sourced by AXA IM as at 14 September 2018.

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