Fixed income

Why inflation-linked bonds could offer value in the post-COVID-19 environment

Highlights

  • Inflation in 2020 will be close to zero, a level priced in by the market
  • Expectations for inflation are depressed, but we see upside risks
  • Those include the oil price base effect and rising prices in some key sectors
  • Downward pressure may come from more online pricing, while COVID-19 has given statistical agencies a headache in terms of data construction
  • We see quantitative easing providing support for inflation-linked bonds in the medium term
  • Other inflationary factors might include protectionist trade policies or a regulatory effect from green policies
  • In this environment, we believe inflation bonds could offer value to long-term investors, particularly at the front end of the curve

As global markets attempt to recover their poise in the relentless shadow of COVID-19, one hot topic has perhaps challenged economists more than any other: What will be the pandemic’s effect on inflation? We are sure of one thing – in 2020, the inflation rate will be between zero and 1%, and this is already priced in the market. But the picture for 2021 is only now starting to clear, and we think reveals a potential opportunity for investors through inflation-linked bonds.

Many experts predicted the global coronavirus lockdown would be disinflationary – and they were right. The fall in activity did have a clear effect on prices for a variety of reasons. At AXA IM, we now forecast 2020 inflation to average 0.4% in the Eurozone, 1.0% in the US and 0.7%[1] in the UK – rising to 0.7%, 1.4% and 1.5% respectively for 2021. The impact, however, has not been a one-way street – we are already starting to see signs of higher pricing in some sectors which could suggest market expectations are too low.

One factor that has served to depress core inflation has been the inclusion of more online pricing into the data, an understandable measure given the impact of the lockdown on consumer behaviour. However, we believe several other factors are having the opposite effect. Food prices, for example, have tended to climb during this period, as have telecoms prices after a long period of decline.

Hidden effects

In some areas we are still assessing the longer-term trend, although there does appear to be some evidence that education and health prices could continue to rise, alongside some localised trends in leisure and tourism services where consumers are no longer travelling to cheaper destinations. Inflation surveys could have a difficult job adapting to new realities in consumption patterns.

More fundamentally, there is evidence that the post-lockdown response from consumers has pushed some economies towards a more aggressive rebound than had been feared, accompanied by a parallel rise in prices. Figure 1 below shows that recent inflation numbers in the US have been the most solid seen in years, and that the rebound has been broad-based. In addition, as we move into 2021, inflation numbers worldwide will reflect a negative base effect from oil prices, which slumped as the pandemic spread.

From a more macro perspective, we see a medium-term risk that the COVID-19 outbreak could exacerbate tensions in the current model of globalisation. Pre-pandemic – alongside US President Donald Trump’s ‘America First’ approach to trade – there had already been a shift towards a more protectionist tone in global markets. Now the virus has forced countries and businesses to re-assess the flow of goods, services and people across borders.

Hedging into view

These observations mean we believe there is a general risk to the upside for inflation as we move into 2021. And it is a risk that we believe has not been adequately reflected in market expectations.

One way to gauge how markets expect inflation trends to evolve is to look at inflation swaps. The chart below (Figure 2) shows that realised inflation since June is consistent with the top-end outlooks for inflation. The inflation swap market, however, is still pricing in the lower end, particularly in Europe but also to some extent in the US. Our expectation is for a potential aggressive rebound of inflation at the beginning of 2021, and we believe investors should consider preparing for that eventuality.

Naturally, these factors to the upside are encouraging more investors to explore ways they can hedge inflation risk. This is adding a further boost to an inflation bonds market already underpinned by the twin effects of active monetary policy and supportive fiscal policy. In fact, we expect sustained quantitative easing (QE) programmes will help the inflation-linked bond market in the medium term. Consumer behavior, the rise of protectionism and the possibility of regulatory price effects (for example through green policies) will be central to the potential uptick in prices – but central banks will also do what they can to push inflation higher from this point.

Our strategy for these market conditions is to take a selective, active approach. For example, we were underweight inflation-linked bonds in February and March, and benefited from a drop in oil prices and the subsequent fall in inflation expectations. As central banks unveiled stimulus measures to support their economies and began to aggressively buy bonds, in a move that we believed would push real interest rates lower, we increased our weighting in long-dated inflation-linked bonds.  

Right now, we believe that there likely exists a better risk-reward ratio at the front end of the curve, in short duration bonds, particularly when factoring in the negative base effect from oil prices we expect early next year. Valuations are not as cheap as they were immediately after the March shock, but our assessment is that this part of the market still holds potential pockets of value.

For investors keen to keep some duration, an ‘all-maturities’ strategy remains an alternative. With interest rates tending to stay low and QE here for the long haul, investors could perhaps look to hold duration in an inflation-linked strategy.  We currently see potential opportunities in areas including short-duration core Eurozone inflation-linked bonds, and US Treasury Inflation-Protected Securities, which we expect to benefit from QE, as well as Australian inflation-linked bonds.

In both cases, a global diversified approach can potentially offer a better risk-return profile. Inflation is a global phenomenon, after all, and diversification in sovereign bonds has clear potential advantages, particularly now that currency hedging costs have fallen[2].

[1] AXA IM estimates

[2] The currency hedging cost of carry for USD assets to EUR was at 2.7%/year in 2018. Currently it is at 0.5%. Source: AXA IM/Bloomberg

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