At the beginning of the year, volatility in the oil and commodity complex had markedly increased, along with the fatter tail risk of a hard landing for China. In a global context, market sentiment was characterized by fears of deflation and a weaker growth profile, putting further onus on monetary expansion polices, especially those of the European Central Bank (ECB) and Bank of Japan (BOJ). Similarly, it has led the U.S. Federal Reserve (Fed) to be more patient and cautious around raising interest rates. At the time, the five-year U.S. breakeven inflation rate, defined as the difference between the five-year U.S. Treasury bond yield and the five-year U.S. Treasury inflation-protected securities (TIPS) yield, fell below 1%. Heading into 2017, global deflation risks have materially subsided. G10 headline inflation measures have broadly shifted higher, via positive base effects from oil price normalization, and have surprised markets to the upside. Both breakeven inflation rates and forward market-based measures of inflation expectations have begun to adjust.
In our view, the recent shift higher in global inflation expectations underlines the fact that inflation-linked securities should benefit most among asset classes at risk of a repricing of the inflation-risk premium, as easing of the previous deflationary forces, notably the strong U.S. dollar, price declines in the energy complex and slack in the labor market should push inflation higher. These tailwinds for higher U.S. inflation are now amplified by President-Elect Donald Trump’s U.S. presidential election victory; fiscal stimulus is expected to kick in quickly—with more spending on defense and infrastructure, and a restructuring of corporate taxes—thus closing the output gap and boosting core inflation. U.S. Core CPI stands at 2.1% year-over-year and U.S. headline CPI year-over-year is likely to exceed 2.5% early next year. Other measures of U.S. inflation and surveys, such as the Cleveland Fed Median CPI and the University of Michigan 5 to 10-year inflation expectations, already point above 2.5%. In comparison, both U.S. 5-year, 5-year forward breakeven expectations (a measure favored by the Fed) and the 30-year U.S. cash breakeven inflation rate (currently the highest point on the U.S. cash breakeven curve) sit nearer to 2%. This suggests that the probability for U.S. breakeven rates to advance further is high, and that U.S. TIPs are still attractive to own relative to their underlying nominal counterparts.
Interestingly, the U.S. Federal Reserve does not seem too worried about the rising price pressures described above. It appears that there is some willingness from some central bankers to tolerate above-target inflation rates over their forecast period in order to achieve a more sustainable and firmer economic growth trajectory. On October 16th, U.S. Federal Reserve Chair Janet Yellen stated that the economy has seen an unusual tendency of weak demand against strong supply, making it reasonable “to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a ‘high-pressure economy,’ with robust aggregate demand and a tight labor market”.
Echoing the Fed, from the UK monetary policy standpoint, Bank of England (BOE) Governor Mark Carney remarked “it was better not to have another 400,000 or 500,000 people unemployed in order to get inflation right back to target at exactly two years.” He also stated that the BOE will allow inflation to run “a bit” higher than its target to aid both employment and output growth.
Overall, we forecast inflation prints in many G10 countries will post higher than, or close to, the 2% target—except for the UK and the U.S., where we expect the headline CPI average well above 2% within the next two years. While inflation trajectories in Japan and the Eurozone remain low, make no mistake, their respective central banks are actively in pursuit of generating higher rates of inflation.
While the value and cyclical aspects are growing in support for U.S. TIPS and global linkers, it is now reinforced by strengthening sentiment towards the asset class. Flows into inflation-protecting strategies via global inflation-linked exchange-traded funds (ETFs) and mutual funds have gained significant traction with strong, positive accumulative net flows this year. Unlike 2015, the demand and supply dynamics of oil should also be helpful for the global breakeven rates on the beliefs that: 1) in China, there is sufficient evidence that improved industrial activity will require upside revisions to oil demand and raw metals, and 2) OPEC producers want a higher price of oil, so it is more likely than not they try to regulate supply, thus implying that positive base effects could persist for the next few quarters and that the trend higher in headline inflation stays intact.
In conclusion, Standish expects headline inflation (from which inflation-linked bonds are priced) across most developed countries to creep up over the next 12 months. Coinciding with the overt richness of nominal bonds, it makes sense to us to diversify and provide some buffer to the performance of a multi-sector strategy in the event of a significant market correction.