The stabilisation of US economic growth amid unprecedented fiscal and monetary stimulus has raised questions about the likelihood of inflation returning. Global Head of Fixed Income, Jim Cielinski, and Global Bonds Portfolio Manager, Andy Mulliner, explain why they do not see significant risk of sustained higher inflation materialising in the next few years — but caution that short-term spikes are possible and that investors should evaluate the diversification that their fixed income portfolios provide.
For most investors, inflation has long been a negligible concern. For over two decades, the US consumer price index (CPI) has wobbled around the 2% level and the few significant deviations from that range were not surges in inflation but collapses. Central banks, understandably, have been more focused on fueling their economies by lowering interest rates toward, or through, zero.
The unexpected shock of Covid‑19 prompted the US Federal Reserve to return its official policy rate to zero for only the second time this century. Other central banks across the developed world initiated unprecedented quantitative easing (QE) — the direct purchasing of bonds to provide companies with credit and put more money into the real economy. Meanwhile, trillions of dollars in ‘stimulus' programmes have been implemented by fiscal authorities. As economies have begun to stabilise, investors have increasingly started to wonder: where is all this money going to end up? Will massive QE and historic fiscal spending result in a return of inflation?
Will inflation rise meaningfully?
In our view, significantly higher global long‑term inflation is certainly a risk but it is not a certainty. While money supply has surged globally (registering the fastest growth since World War II), how that money moves through the economy is as important as the amount. If the increased supply of money were to start moving faster through the economy, the risk of inflation would rise. But creating demand for money, perhaps counterintuitively, is not as easy as creating its supply.
The global economy has recovered from the lows set in the first half of the year, but there is still vastly more supply of, than demand for, goods and services across the developed world. Even with optimistic scenarios for vaccine distribution, it will take a few years of strong economic growth to close the gap between supply and demand. Of the world's major economies, only China is expected to fully recover before the end of next year. The US economy is not expected to get back to pre‑pandemic levels until 2022, and Europe not until between 2022 and 2025.
Nevertheless, US CPI could reach 2.0‑2.5% in the first half of next year, not far from where it was before the pandemic. While such a figure would be a significant increase from current levels, the 2020 levels were low enough that a modest rise in prices could have a significant impact on the year‑on‑year change, which is how CPI is calculated. Regardless, this should not be confused with a regime shift to higher inflation, which will require significant, and sustained, economic growth.
What we are watching
A reversal in money velocity would signal an increase in the demand for credit, suggesting that the economy might be on a path to self‑sufficiency, falling unemployment and thus, eventually, inflation. Another, albeit less likely, indicator of rising inflation risks is more political. The US election looks most likely to result in the parties sharing control over economic policy, with a Republican controlled Senate limiting Democrats' ability to spend. However, it remains possible that the Democratic Party gains control of the Senate and embraces a view that low interest rates are a consequence free way to spend. Should the market begin to suspect an abandonment of fiscal responsibility, it could begin to price in higher inflation expectations.
Portfolio positioning in a low yield, modest inflation world
As it will take time to close the gap between supply and demand, and the Fed will likely want to see longer‑term rates contained to help fuel the recovery, we expect government bond yields are unlikely to rise sharply. However, investors should carefully consider their exposure as risks to our mostly benign outlook remain. The absolute level of US Treasury yields are historically low and provide little compensation for the risk of rising inflation — or rising yields, regardless of the cause.
In our view, investors should redouble their focus on realising income and achieving diversity. Floating rate exposure or instruments like Treasury Inflation‑Protected Securities (TIPS) could help hedge interest rate risk. Credit markets, including corporate bond markets and securitised sectors like mortgage‑backed securities (MBS), could also flourish in an environment where inflation is modestly higher but the demand for yield remains strong. While the duration of corporate bonds is relatively high by historical standards, combining these exposures with other lower duration fixed income products could result in more attractive risk‑adjusted portfolios.
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 Deutsche Bank, Janus Henderson Investors, Bloomberg, as at October 2020