Time to look again at inflation-linked bonds?

After years of being under-invested and under-researched, and as inflationary pressures grow, it’s time for investors to consider reassessing their exposure to inflation-linked bonds.

14 October 2016

Michael Lake

Michael Lake

Investment Director, Fixed Income

Ultra accommodative monetary policy has inflated asset prices, but has had little impact on consumption of goods and services.

This combined with low commodity prices, particularly oil, has taken headline inflation to artificially low levels.

As a result, market expectations of future inflation have dwindled and participants have profited from further monetary stimulus through exposure to nominal bonds that have increased in value while interest rates have idled at or below zero.

However, with monetary policy overstretched and broadly ineffective, policy makers have begun to look towards expansionary fiscal policy to simulate economies.

Such large scale fiscal expansion would likely entail higher government spending or tax breaks that would impact final demand by directly stimulating the economy through development of infrastructure resources.

Such measures are likely to be inflationary and could be a boon to inflation-linked bonds, but do investors need to wait to see firm announcements of such policies before investing?

Inflation expectations

Inflation-linked bonds pay income that is adjusted based on official headline inflation data; however, demand for inflation-linked securities is driven by expectations of future inflation.

Currently, financial markets have extrapolated low levels of official inflation into the medium term. We believe this represents an opportunity. Should inflation expectations increase, and we believe that they could, active investors could profit.

Energy impact

One of the key components of headline inflation and a major driver of low inflation in recent years has been the sharp decline in the price of energy costs, primarily oil, the cost of which declined over 60% from mid-2014 to early 2016.

As headline inflation is calculated on a rolling 12-month basis the impact of the fall in oil prices diminishes with the passing of time and providing the price of oil does not fall further.

Indeed, from the trough established at the start of 2016 oil has rebounded over 50% and the impact of the fall in the price of oil will pass out of the calculation period in the first quarter of 2017.

Core inflation which excludes energy is currently higher than headline inflation and as the base effects pass out of the calculation headline inflation should begin to converge on core inflation.

While the mechanical impact of the change in energy prices and the rolling nature of the calculation of recorded inflation are important aspects to be considered, they alone do not argue for a sustained and long-term increase in inflation.

Demand increase required

There are increasing signs that global inflationary pressures are starting to build with commodity prices, input prices and tightening of labour markets all contributing to growing concerns regarding potential future inflation.

However, any sustained uplift in inflation would need to see the type of increase in demand for goods and services that could be the result of increased government spending.

In that vein, the recent Brexit shock, which itself caused a spike in UK inflation expectations given higher “imported inflation” from a weaker currency, has led to a less austere response from the UK government which is now openly discussing the prospect of direct government intervention to stimulate the economy.

Convergence of inflation drivers

In Europe, Mario Draghi, President of the European Central Bank (ECB), has regularly called for government reform to simulate economies and the Bank of Japan stated that it would aim to overshoot its inflation target.

Meanwhile, with the US election fast approaching, the policies espoused by both Republican and Democratic nominees are expansionary in nature.

Arguably therefore, both the technical and government policy drivers of inflation expectations appear to be converging.

We believe investors who continue to overlook the inflation-linked asset class are therefore excluding a potentially key source of return from their opportunity set.

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