In the recent market turmoil, the German 10-year bond yield turned negative for the first time. An unprecedented 31% - equivalent to $8.3 trillion - of the bonds in the JP Morgan Government Bond index now trade on a negative yield. In other words, vast swathes of the bond market now offers no protection against inflation, and, in many cases, assumes deflation.
There are arguments to support this view: years of monetary policy stimulus have produced only anaemic growth. There is increasingly credible discussion of extraordinary policy measures, such as helicopter money. However, many fund managers now believe the risks are skewed the other way, with markets paying insufficient attention to the potential for inflation, at a time when inflationary pressures are starting to emerge.
In the US, wage growth is picking up tentatively, in spite of the recent weak jobs figures. In the UK, CPI inflation was unchanged in May at 0.3% and has not hit the Bank of England’s target of 2% for more than two years, but wage growth is increasing.
The latest data from the Office of National Statistics shows earnings rising 2.3% per cent year-on-year in the three months to April, ahead of expectations. In April pay growth jumped to 2.5% from 1.9% in March.
Commodity Price Rises Could Soon Push Prices Upwards
Higher resource prices may also start to have a more significant impact on the figures in the coming months. The recovering oil price will start to be reflected in inflation figures from September onwards, along with higher commodity prices elsewhere.
Fund managers have been adjusting. In mid-June, Ian Spreadbury, portfolio manager of the Fidelity Strategic Bond fund, said he had significant reduced duration, citing the ‘extraordinary rally’ in government bonds witnessed over the last fortnight. He added: “Government yields are well below expectations for nominal growth and we believe a significant deterioration in inflation and growth, or an expansion of monetary support globally, is needed to justify current valuations.”
Inflationary Pressures in US Markets
Rory McPherson, head of investment strategy at Psigma, believes the headline figures do not tell the whole story on inflation: "Inflation in the US has been picking up, largely as a result of the stronger currency, even though it is below the Federal Reserve’s measures.
"Core inflation is above 2% and we are seeing wage pressures rising. It is coming back and we do believe inflation pressures are there. By doing nothing, the US will stoke inflation pressures.”
As a result, he is avoiding very expensive government bonds that offer little or no protection against inflation and focusing on higher growth assets in his portfolio.
McPherson adds that UK bond markets are currently pricing in a rate cut: “As such, it is not a good trade-off to own very expensive bonds. They have no growth prospects. We are focusing on growth type fixed income assets, such as high yield. To our mind, these offer sufficient compensation for potential interest rate rises. In equities, investors need companies that are either cheap or growing their earnings.”
Paul Flood, a fund manager on the Newton multi-asset team, believes the policies of central bankers have created a naturally deflationary world: “The policies since the global financial crisis have helped keep ‘zombie’ companies alive. They have kept pricing down and lower inflation expectations at a time when demand was low anyway. Lower interest rates tend to create the misallocation of capital.”
Bond Markets Offer No Protection From Inflation
This is likely to see the low growth, low inflation world persist. However, in his view, this does not argue for focusing on government bonds or similar assets. He says: “When inflation picks up, people price it in quite quickly. German government bonds are paying 0% for 10 years. They have no protection against inflation.”
He likes companies with a secure and growing dividend that can be paid irrespective of the market backdrop. These tend to have a good correlation with inflation. He adds: “Index-linked bonds are more expensive, but areas such as renewables and infrastructure have that inflation-hedging characteristics. These are undervalued in our view.” He points out that in a lower growth world, the price paid for assets becomes extremely important, and for government bonds, the price is negative.
Could a Brexit Stoke Inflationary Fears?
Clearly the outcome of the referendum, undecided at the time of writing, could affect inflation expectations across the UK and Eurozone. If the vote is to leave, government bond yields may narrow further as markets price in lower inflation expectations, but they have already moved in a long way and it may be temporary.
Even if the low growth, low inflation environment persists, this is largely priced into markets. The alternative – a pick-up in inflation, however small – is not. This suggests the risks are skewed to higher inflation. If there is no inflation or deflation, markets remain unchanged, but any hint of inflation could prove disruptive. Fund managers are increasingly making sure that they aren’t caught out.
