AVUV - High Conviction: Inflation-Linked Debt

2023-04-10 11:30:00 ET

Summary

• We upped our overweight of inflation-linked bonds in March to quickly take advantage of the market pricing lower inflation - our new playbook in action.
• Bond yields rose after data showed a still-tight U.S. labor market. We think that keeps inflation sticky and makes Federal Reserve rate cuts this year unlikely.
• U.S. inflation data this week will show core inflation remaining well above the Fed’s 2% target. We don’t see the Fed hiking enough to get it all the way to 2%.

Transcript

Typically, inflation and breakeven would fall heading into a recession. But we’re not expecting a typical recession.

There are cyclical forces, cyclical forces like goods deflation and an energy crisis coming down that have driven inflation lower in 2023. But even that we can’t take for granted.

Structurally, there are forces such as net-zero transition, such as geopolitical fragmentation, such as labor shortage that points to inflation settling at a level that is higher than what we got used to pre-pandemic.

As we entered 2023, we launched a new playbook where everything hinges on what’s in the price. And if you look at inflation pricing, in the U.S. pricing points to low 2s, which is too low. In Europe, we are looking at high 2s, which is a tad higher than what we would expect, which is why we currently have an overweight for U.S. inflation-linked bonds versus its European counterparts but also versus nominal long-duration bonds. More broadly, it is really important to think about inflation protecting our portfolios.

Real assets play a role as well, and equities too. Here is really interesting, strategically we’re overweight developed market equities in part also because of inflation hedging portfolio, but tactically we’re modestly underweight because things could get worse before it gets better, especially as we head into Q1 earnings reporting season.

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Major central banks are hiking rates into recession to try to get inflation to policy targets. Inflation fell when past recessions hit. Pushing inflation to target now calls for a major recession. We expect a recession to help cool inflation but think the Fed will stop hiking before it gets severe. This week’s data is likely to show U.S. inflation staying sticky. We think market pricing is underappreciating persistent inflation and took advantage of the dip in expected inflation in March to up our overweight.

Sticking around

Notes: The chart shows U.S. CPI and core CPI inflation and market pricing of what inflation will average over the five-year period that begins five years from today - also known as the 5-year/5-year inflation swap. Forward looking estimates may not come to pass.

Inflation-linked government bonds behaved more like risk assets in the past, underperforming nominal government bonds in economic downturns. Concerns about bank stability and recession spurred a return of this old behavior last month. That’s the old playbook, in our view. U.S. core inflation is not on track to fall to the Fed’s 2% target, like markets expect (see the green dot above). February Personal Consumption Expenditures (PCE) data confirmed this. We expect the Consumer Price Index ((CPI)) data out this week to do the same. Lower energy prices and falling goods inflation as consumer spending shifted back to services initially led a decline in core CPI inflation (yellow line). But some goods inflation is already ticking back up. A tight labor market that’s boosting wage growth and services inflation is also making core inflation stubborn. Plus, supply shocks - like the surprise OPEC+ oil production cut - may cause brief spikes in headline inflation (dark orange line).

The Fed is sticking to hiking rates to get inflation down to target, even as financial cracks start to appear. We think the Fed will eventually stop hiking when the damage becomes more apparent. That means it won’t have done enough to create the deep recession needed to achieve its inflation goal, so it will be living with some above-target inflation. Updated Fed forecasts last month noted as much, with PCE inflation floating around 3% at year-end - even as the Fed expects growth to stall.

New playbook in action

The breakeven inflation rate - or the market’s pricing of future inflation - narrowed in March as markets saw inflation falling to 2% given the bank turmoil and nearing recession. We were already tactically overweight inflation-linked bonds. We used the repricing to go more overweight. Any old playbook-style underperformance of inflation-linked versus nominal bonds presents opportunities, in our view. We think the market pricing in repeated rate cuts suggests investors are underestimating inflation’s persistence and expecting central banks to come to the rescue. We see sticky inflation preventing cuts in 2023. The magnitude of our tactical overweight is now closer to our longstanding overweight from a strategic view of five years and beyond as structural trends like aging populations, geopolitical tension and the energy transition keep inflation higher.

We are neutral on euro area inflation-linked government bonds and prefer U.S. counterparts. The reason: European inflation is more likely to reach the European Central Bank’s (ECB) 2% target. Not because inflation is less persistent - getting inflation to 2% will take a recession, just as in the U.S. But unlike the Fed, we see the ECB going full steam ahead with rate hikes to get inflation to target - regardless of the damage that entails. Consumers seem to agree, with their inflation expectations over three years ticking down closer to the ECB policy target, according to February ECB survey data. But at the moment, euro area inflation pricing is even higher than in the U.S. - and thus less attractive, in our view.

Our bottom line

We think U.S. inflation will remain above the Fed’s target for some time. We wield our new playbook and seized the opportunity to add to our existing tactical overweight to inflation-linked bonds in March - one of our highest-conviction views. We see structural trends supporting higher inflation, so we’ve been overweight strategically for a few years. We like other assets that help portfolios with higher inflation. Infrastructure assets have the potential to hedge some of the effects of inflation, too. We remain tactically underweight developed market shares and expect corporate earnings to come under pressure - and the upcoming earnings season starting this week may reveal such damage. We prefer emerging market peers that better price in the economic damage we expect.

Market backdrop

U.S. and European equity indexes ended largely unchanged on the week heading into the Easter holiday. U.S. Treasury yields ticked back up after the U.S. jobs report showed another solid gain in payrolls, with the unemployment rate dropping back near a five-decade low. The market priced back in a potential Fed hike in May but is still eyeing multiple rate cuts later in the year. We don’t see the Fed cutting policy rates later this year, and prefer short-term government paper for income.

The focus is on the U.S. CPI this week. It is likely to show that inflation is proving sticky and not on track to quickly fall to the Fed’s 2% target. We think the market is underappreciating how persistent core inflation is proving. U.S. retail sales and consumer sentiment could offer signs of how much the Fed’s rate hikes are cooling economic activity.

This post originally appeared on the iShares Market Insights.

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