Inflation: Here Today, Gone Tomorrow?
With its Core Consumer Price Index rising 4.0% for the year ending August 2021, the US finds itself the center of concern around rising inflation. We believe this jump in inflation is transitory. We expect price increases to decelerate as pandemic-induced supply constraints gradually ease, allowing supply to catch up to demand and taking the pressure off prices.
Could inflation become a worry in the euro area? Not anytime soon. The European Central Bank recently put its 2023 inflation forecast at just 1.5%, highlighting how far it is from achieving its inflation goals (and indicating that ongoing asset purchases will be needed long after the Pandemic Emergency Purchase Programme expires).
However, in coming years, as governments struggle to repair the economic damage from the pandemic, manage massive debt levels and address the urgent challenge of climate change, once-in-a-generation policy change will open the door to higher inflation, in our view.
While we don’t think inflation will become the concern it was 50 years ago, investors are wise to make some adjustments to their portfolios. Even moderately higher inflation erodes the real value of investment returns and often leads to higher interest rates. In today’s climate, investors might consider these strategies:
- Modestly reduce the portfolio’s duration, or sensitivity to interest rates. Prices on shorter-term bonds fall less than those on longer-term bonds as market yields rise. Shorter bonds can also be reinvested sooner in higher yields.
- Tilt the allocation toward credit to capture incremental yield and income. That includes increasing exposure to high-yield corporates. Bonds that offer a yield spread above government debt—corporates, for example—are less sensitive to changes in interest rates. And the wider the spread, the less sensitive the credit.
- Diversify globally across higher-yielding sectors, such as US credit risk–transfer securities (CRTs), with low correlations to government bonds and to each other. CRTs are floating-rate bonds backed by real assets—homes—that often benefit from inflation. Thanks to a robust US housing market, fundamentals look attractive for CRTs. Select emerging markets also look attractive and provide a diverse source of potential return.
Tapering Without Tantruming
While inflation has the potential to drive yields higher, so too does the unwinding of easy monetary policy. Once again, fears around rising rates center on the rapidly recovering US economy, which as soon as November will require tapering of purchases in the US Federal Reserve’s quantitative easing (QE) program.
However, we don’t foresee a “taper tantrum,” for two reasons. First, the Fed has learned from its mistake in 2013, when it surprised the markets with a change in monetary policy, triggering a dramatic spike in yields. This time, the central bank has laid the groundwork well in advance to avoid surprises. Second, as the Fed steps back from bond-market buying, US banks are likely to increase their bond purchases to meet their increased need for income.
Tapering will be the first step on a long path toward normalization of monetary policy. The Fed will probably slow the pace of its asset purchases gradually and still be buying bonds well into 2022. Once QE purchases stop entirely, the Fed will continue reinvesting coupons and maturing bonds, making it a major player in bond markets for years to come. Once it reaches this steady state, we expect the Fed to keep the policy rate at zero for several months before eventually embarking on rate hikes.
The result over the next year or two should be a gradual rise in US bond yields, with 10-year Treasury yields climbing modestly higher by year-end 2022. Meanwhile, yields in the euro area and Japan should remain near zero, while yields in China, which has bucked the extreme-yield trend, should remain comparatively high.
Unfortunately, these conditions leave investors between a rock and a hard place. On the one hand, bottom-scraping yields threaten to scuttle a portfolio’s return potential. On the other hand, the path to higher yields, though helpful in the long run, can be painful as bond prices initially decline. What’s an investor to do?
In our view, the strategies we already noted—shorten duration, tilt toward credit and diversify—are a solid start. But in today’s climate, investors can do more. Among the most effective active strategies are those that combine government bonds and other interest-rate-sensitive assets with growth-oriented credit assets in a single, dynamically managed portfolio.
This approach can help managers get a handle on the interplay between rate and credit risks and make better decisions about which way to lean at a given moment. The ability to rebalance negatively correlated assets helps generate income and potential return while limiting the scope of drawdowns when risk assets sell off.
Let It Go: China and Evergrande
The Chinese credit markets saw one such sell-off recently when Evergrande, the biggest and most indebted property developer in the world, began defaulting on its mountain of debt. Market observers publicly wondered whether China’s policymakers would bail the company out.
Rigorous credit research is critical during any tumultuous period, since individual company defaults and debt restructurings are possible. With China, that kind of research means also assessing the government’s willingness—or unwillingness—to let a given company fail. In other words, investors need to apply a systematic framework to better anticipate which companies Beijing considers systemically important.
In Beijing’s eyes, Evergrande doesn’t warrant rescue. That’s because no single property developer—not even Evergrande—is systemically important in the context of China’s huge economy. Allowing unhealthy companies to fail furthers China’s goal of improving its corporate market’s overall health. That’s good for credit investors.
That said, while neither Evergrande nor its peers are systemically important on an individual level, China’s property sector, taken as a whole, is. Property developers and the sectors that depend on them, such as suppliers of heavy equipment and building materials, have total debts of RMB 101 trillion—amounting to 35% of China’s financial system and equivalent to 100% of the country’s GDP.
So, while individual property developers might be allowed to fail, Beijing is very likely to take steps to ensure that the fallout for the sector will be limited. Should signs of contagion grow, we expect Chinese authorities to help ease funding pressures and help rekindle investor confidence through coordination with the large state-owned banks and through potential policy adjustments.
We expect most property developers in China to muddle through this period of short-term volatility. However, financial market turmoil could prove self-fulfilling, if diminished access to offshore bond markets render property developers’ offshore refinancing unviable for an extended period.
Active investors should therefore look for issuers with the ability to weather extended market volatility. Typically, this means having access to other liquidity sources or owning quality assets that can be monetized, if necessary. Investors should also keep an eye out for potential opportunities, where bond prices have become distressed.
Tune into Climate and Other ESG Risks
Climate and other environmental, social and governance (ESG) risks have also begun to emerge as a top investor concern. Investors who are eager to buy bonds that will help create a better, more sustainable world can start by learning the pros and cons of the various ESG-linked bond structures. But mitigating ESG risks doesn’t stop with buying green bonds.
To fully capture and manage the risks and opportunities created by ESG, managers must thoroughly incorporate ESG factors into bond analyses and investment processes. Even investors who don’t prioritize ESG stand to benefit from the integration of ESG factors into the investment process. From catastrophic environmental events to more favorable financing terms, ESG impacts every bond issuer’s bottom line.
Lastly, it’s hard to manage what you can’t measure. That’s why we’ve developed a robust, forward-looking method for measuring your bond portfolio’s carbon footprint.
Make Technology Your Friend
Manager tech isn’t top of mind among investors, but it should be. Advanced technology can help bond managers scan the entirety of the bond market in real time, suggest potential trades, build out trades in seconds and invest new portfolios more quickly.
Three years ago, it took an average of 35 days to get a new credit or emerging-market debt portfolio 90% invested. Today, that can be accomplished in half the time—if bond managers have mastered the tech revolution. And every extra day those assets are invested amounts to more interest earned.
Cutting-edge tech allows traders to cut through the noise of thousands of bonds trading at any given time to find opportunities and source liquidity, even when markets become fragmented and volatile. In contrast, bond managers who don’t have the right tech will fall rapidly behind in the post-pandemic world.
Keep Calm and Carry On
The post-pandemic landscape will bring many changes. But don’t let fear send you to the sidelines. With some prudent adjustments, investors and bond managers can weather uncertainty with dispassion, prepare for inflation, rising rates and climate change, and position their portfolios to prosper in the post-pandemic world.