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Is it time for inflation-linked bonds?


Michael Lake

Michael Lake

Investment Director, Fixed Income

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For most investors inflation is not a primary concern at the moment. In truth it probably hasn’t been for a number of years, as price rises have remained relatively contained.

In the later stages of 2019, however, we saw tentative signs that this could be changing with inflation data picking up.

We think there are some fundamental reasons that a pick-up could continue in the near-term. In particular, there is scope for an upturn in the economic cycle in the first half of 2020. This should bring inflation back on the radar for investors and potentially push expectations higher.

Why consider the impact of higher inflation expectations?

One of the perennial challenges investors face is achieving positive inflation-adjusted returns. An investment return which undershoots the inflation rate effectively reduces the value of the invested capital relative to the overall cost of goods in the economy. As such, the value of the capital would be said to have declined in “real terms”. Investors may also wish to monitor whether investment returns are providing sufficient compensation over and above inflation for the risk taken.

This becomes a more important consideration during periods where recorded inflation is picking up. At such times, inflation-linked bonds, or “linkers”, can help investors mitigate this risk, because the value of the bond and the interest it pays rises and falls with inflation. In other words, rising inflation should result in higher returns from inflation-linked bonds.

Are central banks targeting higher inflation?

Central bank policy is a key factor. Policymakers remain strongly inclined to set policy to promote growth. They even appear willing to allow a period of above-target inflation in order to “re-anchor” expectations back at a higher level.

We expect to see the positive impact of interest rate cuts and other monetary easing measures from 2019 to start to feed into economic data. The US Federal Reserve (Fed) staged a dramatic U-turn by cutting interest rates three times in 2019. The Fed is keen to elongate the expansion stage of the economic cycle, which is already the longest on record and showing signs of maturing, through policy measures.

In doing so, the Fed is implicitly allowing room for inflation to exceed its 2% target, or to allow the economy to run hot as a means to re-anchor inflation expectations around the target level. The Fed’s motivation is understandable. It was not so long ago that deflation risk was being discussed.

As the chart below illustrates, looser financial conditions often lead to a rise in inflation expectations over time, and it is during these periods that government inflation-linked bonds generally outperform nominal (non-inflation-linked) government bonds.

Looser-monetary-conditions-could-push-inflation-higher.png

The European Central Bank (ECB) too is attempting to reflate the region’s economy, cutting rates further into negative territory and re-starting its quantitative easing measures, such as bond purchases. Recorded inflation and inflation expectations started to rise in the later stages of last year as monetary policy support and improved sentiment started to feed through into data.

In Europe too, recorded inflation and inflation expectations started to rise in the later stages of last year as monetary policy support and improved sentiment started to feed through into data.

Euro-area-monetary-conditions-have-loosened-notably.png

Ultimately, central banks seem prepared to allow above-target inflation, or to run their economies hot, so as to sustainably shift inflation expectations back closer to their targets.

Why does market sentiment drive inflation expectations?

Some issues that have weighed on both business and investor sentiment and impacted global growth are fading and potentially even reversing. Political developments have increased the chances of a more positive Brexit solution, or at least significantly reduced the risk of a negative shock, while the US and China have made meaningful progress with trade negotiations.

This has already lifted sentiment and if both situations remain on their current course, should provide a short-term boost to activity, sufficient enough to beat currently downbeat market expectations of growth. In an environment where central banks remain accommodative, this is likely to begin to feed through into inflation measures, both expectations and realised.

Can fiscal stimulus provide support?

Meanwhile, governments are coming under increasing pressure from a growing populist movement to expand fiscal deficits in order to address inequality. While we envisage only a modest fiscal boost, relative to 2019, the pace and extent governments react is likely to differ across countries.

Where policymakers are proactive, there could be a domestic inflationary impact. In the UK, the Conservative party’s plans for fiscal spending in its election campaign proved more modest than the economic and political circumstances would have enabled. But compared to other markets, this might be still be enough to ignite inflation expectations. In such a scenario, inflation-linked bonds ought to be a good place to be.