Inflation remains issue number one

Our outlook for the global economy remains upbeat. Most of the developed world will achieve above-trend growth rates both this year and next. But growth expectations look to be reaching a peak. The bond market seems to be aligned with this view, given that yields have moved sideways since the end of March. A lot of the good news about the global economic recovery is now in the price and is consistent with what we are seeing in the data, which has taken a breather in April and May.

At the same time, we have raised our view on inflation – and the market has too. However, there is elevated uncertainty about whether the increase in inflation will prove temporary or become permanent. There are clearly some temporary components to the current rise in inflation. Just as last year we saw demand fall more than supply and inflation temporarily decline; this year we are seeing demand recover ahead of supply and inflation rising as a result. A persistent rise in inflation could bring forward tightening from central banks and possibly undermine the valuation of risk assets. There are two key triggers for longer lasting inflation: first, the temporary spike we are seeing in prices raises inflationary expectations substantially; and second, a sharper rise in wages driven by worker shortages alongside labour market tightness. Whether the higher near-term inflation becomes more entrenched is - in our view - one of the most important investment issues, and we are conducting additional research into it.

Fiscal incentives and monetary reaction functions are their most coordinated since the mid-1960s to late 1970s; an era when fiscal deficits and inflation were positively correlated. For this reason, cyclical inflation needs to be monitored much more closely during this cycle. We may not know the significance, nor the success, of 2020 and the apparent regime change for years – but what we can judge now is that inflation risk premium looks fairly priced in markets. We have leaned against this move-up in inflation pricing by selling inflation-linked exposure at the front of the yield curve where expectations of higher inflation are now very elevated. This position can work in several ways: first, if inflation disappoints over the shorter term; or second, the US Fed starts to move towards removing accommodative policy, driving real yields higher.

With the developed world moving through the early phases of expansion with good prospects for sustainable above-trend growth, this should allow central banks to start making tentative steps towards removing their emergency stimulus measures. Central banks are warming to the idea of tapering asset purchases. The Fed and RBA are lagging, not leading, this effort. Both are outcome-based average inflation targeting central banks, which explains their slower pivot relative to their peers. It would be very brave of the RBA to move before the Fed. With US inflation overshooting its target, the US Fed needs to decide whether to apply the brakes gently. We expect Fed asset tapering talk to accelerate mid-year, and this should make the RBA more comfortable to signal a move of its own, with less risk of any appreciation of the AUD.

We have somewhat moderated our view on the timing of the next move up in bond yields. Initially we were expecting the second quarter to be when the boom in global growth arrived and the overshoot on inflation started to materialise. This has broadly played out as expected, but we now believe the pressure on central banks will come in the second half of this year with this being the next phase of the move higher in yields. Given this view, and the rise in yields already witnessed, we have moderated our short duration position in the US and moved to a more balanced position across the yield curve. In Australia we have started to position for a flatter yield curve, where we believe front-end yields have some catching up to do. The Australian yield curve is one of the steepest in the developed world and we believe we will see a change in tone by the RBA very soon.

As economies start to reopen, we are seeing some differences in country performance, which creates an opportunity for relative values trades. For example, UK and European rates have lagged the move up in US yields. We have diversified our short duration position into some of these markets. Central banks are also withdrawing policy at different paces. We have seen the Bank of Canada make a first move to taper asset purchases given the strength of the recovery, and the market has moved to price higher front-end yields. Comparing that to Australia, the RBA has continued to support yield curve control and very accommodative monetary policy, even though the Australian recovery is just as strong as Canada’s expansion. This presents an opportunity to play for a convergence of policy where the RBA starts to move away from emergency level stimulus and perhaps the Canadian market has priced in too fast an exit by the central bank.

Credit markets have shrugged off inflation fears for now. Credit liquidity is still plentiful and there is little fear over rising default rates. The move up in market-based inflation expectations is confirming the positive fundamental outlook, while real rates are confirming accommodative central bank policy. It’s the perfect fundamental and technical storm that has kept credit spreads tight. But if inflation fears keep rising, credit will face more volatility. Central banks will eventually respond with tighter policy to stronger growth and inflation, but this may not be an acute risk for spreads.

We remain cautious on those credit sectors that have performed strongly and most vulnerable to a repricing of risk, mainly global investment grade credit and global high yield. We have tactically added back to Australian investment grade credit on recent underperformance from the sector. In addition, we have added modestly to our Asian credit and emerging market debt allocations. These sectors continue to display attractive valuations across our global opportunity set. Our credit positioning is now cautious; respecting negative valuations we have strategically reduced credit exposure over the past months and are now positioned for high quality carry.

With bonds now more attractive at higher yields we are more balanced in our portfolio settings, where we are somewhat indifferent between long-dated government bonds and credit to access high quality carry.  We’re expecting to use upcoming volatility linked to firming inflation that pressures central banks to reposition the portfolio more constructively again.

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