Inflation Assets: The great divide
Anthony Harrington surveys competing views on the direction of inflation and bond yields
One of the most perplexing things for investors today is the way the global economy seems to be precariously balanced between inflation and deflation. Central bankers everywhere would infinitely rather find themselves battling inflation since, as has been said many times, they have few weapons of substance to bring against deflation - apart from the power of the printing press. The problem with that lever is there is little to tell you when you've undercooked or overcooked your intervention. Japan, for example, has undercooked its forays into money printing over the last two decades. Before that, Zimbabwe and the Weimar Republic rather overcooked theirs.
For investors, the question is crucial, since the strategies you would put in place for inflation do not work for deflation. Arun Motianey, director of fixed income strategy at Roubini Global Economics (RGE), says that the house view is that deflation, not inflation, is the real near-term risk. However, he argues that those who feel that the US already has deflation are missing the big picture and looking only at micro pockets of deflation such as service sector prices, particularly in the small to medium-sized enterprise space. But there is certainly no sign of deflation in either wages or core CPI.
"Until we actually come close to seeing deflation in finished goods prices and in wages, we won't really be in a deflationary world in the US. But there are dangers that we could slip into this, and those dangers are more pressing and immediate than any concerns about inflation," Motianey says.
Most economists who fear deflation in the developed world point to large capacity utilisation gaps, and the UK and Europe's current commitment to implementing austerity measures to reign in budget deficits. There are already palpable signs of the negative impact of austerity on the real economy, and not just in Ireland. Stewart Wilson, chief economist at ING, points out that the UK coalition government's programme is having a noticeable impact on bond issuance. However, he also notes that there are both positive and negative elements. On the positive side, he points out that the UK is planning for bond issuance for 2011 to be less than Germany's. "This would be a remarkable achievement if the government is able to meet its targets," he says. "However, there is considerable execution risk about this goal."
Inevitably, quantitative easing by any sovereign makes bond investors uneasy. Wilson points out that with foreign purchases of UK government bonds amounting to some 35% of demand, it was quite easy to see the sharp drop off in the three month rolling demand through the UK's ‘QE2' phase. "We saw demand in the three-month rolling figure fall away to £11bn," he says. "The drop was palpable." But, post-election, the coalition's commitment to cutting the deficit gave investors heart once more, and the three-month rolling figure moved back to £20bn (€22.7bn) as a result.
Rod Davidson, head of fixed income at Alliance Trust Asset Management, points out that volatility at 10 years is about four times higher right now than in prior years. "Historically we were seeing an average daily movement of two basis points," he recalls. "Now it has moved out to eight basis points - which is probably a reflection of the fact that we are nearing the bottom of the rate cycle."
The curve will flatten if the economy delivers some benign numbers in the coming months, he suggests. The market is anticipating this, which is why 10-year bonds are trading at historic lows outside of Japan. Davidson says that he is now defensively positioned in terms of duration - 1.5 years short the benchmark in the Alliance Monthly Income Bond fund, at about 4.75 years. In the short term, the best defence, he suggests, is to put the bulk of the fixed income portfolio into corporate bonds and to hedge out as much of the interest rate exposure as seems necessary.
Davidson argues that right now there is no inflation premium priced into most developed world bond markets, and certainly not the UK's where, despite stubborn 3% annual inflation, 10-year yields are down to 2.8%. "The market thinks it might get some more QE in the UK but we don't believe it," he says. "Once we get the bad news from the coalition government's spending review out the way and people realise that growth is not going to go negative, the bond market will start to focus on the risk of inflation moving over the Bank 's [Bank of England] target level... In the near term we have the VAT hike coming in January 2011 and food prices can be expected to go up. Further out, we expect inflation to head down again but, in the meantime, bond yields should go up."
Daragh McDevitt, head of inflation structuring at Deutsche Bank, offers another perspective. He expects "benign and stable" inflation for the next few years and does not rate downside risks highly. "The current CPI target [in the euro-zone] is 2.75% and you need a risk premium of at least a further 1%, given that the pressure in Europe is to move the target higher, giving you extreme target movement risk," he says. "This could happen in the next five years."
Neil Williams, Hermes Asset Management's chief economist, takes the other side. "The ‘loose for longer' approach is good right now, but this will create disinflation traits and we still feel that the CPI could head back into negative territory," he says, adding that the world is becoming aligned to the idea that main policy rates are on hold at least until well into 2012. "Add to this the fiscal tightening that the euro-zone is going in for and we are now skating very close to the Japanese dilemma."
Although he concedes that US productivity is now better than at any point since the Second World War, he points out that this has been achieved by shedding labour, which adds to the under utilisation/deflationary scenario: "Companies have quite a lot of cash on their balance sheets, but this tends to lead to more M&A activity, which is about synergies and labour and cost savings rather than about job creation."
Valentijn van Nieuwenhuijzen, head of economics and fixed income strategy at ING Investment Management, agrees that the most likely outcome at present is a ‘loose for longer' policy. "People are worried about a bubble in the bond market," he observes. "We do not think so. Markets are clearly pricing for deflationary trends." The consensus reflected in bond prices is for low inflation to appear for three to five years, with a move after that back to central bank targets, with the risks tilted to the downside. "Definitely, deflation is a bigger threat than a sudden sharp increase in inflation. We are all hoping for a modest rise in inflation but you can't start betting on an inflation rate shock, despite QE2."
Van Nieuwenhuijzen has somewhat different anxieties over QE2 than many of his peers. "The monetary transmission mechanism is still heavily disrupted in the developed economies," he says. "This was the case with Japan and it should have taught us that inflation is not our problem. Unless you have excess demand and an overheating economy the likelihood of an inflation spiral is extremely low."
He would like to see a temporary but well-sustained fiscal stimulus for two more years, coupled with dramatic reforms to pension and healthcare to address the longer-term insolvency problems in developed economies which were not the doing of the financial crisis, but were already in the system and remain major challenges to be addressed. "On top of this we have ageing societies, which make funding more difficult and which push up healthcare costs," he observes. "This generates demographic electoral change, with a population that becomes more conservative and less likely to vote in or to tolerate stringent healthcare and pension reform. So the longer governments postpone addressing these problems, the more politically intractable they become."
How does this translate into fixed income strategies? "Although we are at the lower ranges for bond yields for the last few years we are not in bubble territory, so there is no need to dump bonds," says van Nieuwenhuijzen. "This is an important myth to dispel." The steep yield curve continues to deliver a decent premium, and while there might no longer be such a thing as a risk-free asset, German, US, Dutch or Finnish bonds all have very good characteristics, he argues.
Gavin Orpin, head of trustee investment at Lane, Clark & Peacock, points out that pension funds are not that fussed over the three-to-five year strategy. When they talk about inflation risk they are looking out to 2030, not 2012. From that standpoint ‘QE2' is worrying and seems more likely to err on the side of too much, rather than too little. That is how Trevor Welsh, fund manager at Aviva Investors, sees things too. He points out that as ‘double-dip' fears have faded yields have retraced some of their recent gains. "We are definitely recommending to clients that they maintain inflation protection," he says. "Pension funds are looking out 20-30 years and inflation has to be their worry. I can't see the need to protect against deflation on that time frame."
Marcus Molan, who heads liability-driven investment strategy at Legal & General Investment Management, disagrees that deflation can be ignored. "In a negative CPI world, pensions still have to be paid out at a flat rate, while all the scheme's inflation linked assets will be falling in value," he notes. That's an asset-liability mismatch risk that simply has to be managed, he warns, because if deflation gets a grip it can last for decades - witness Japan.