There has been a resurgence of inflation as an investment theme over the past 12 months as inflation expectations have ticked up, writes Standard Life Investments’ Amit Moudgil.
Growing evidence of the sustainability of the economic recovery and the anticipation of a pro-inflation fiscal policy regime in the US has been central to this.
Meanwhile, the Brexit-induced depreciation in sterling has pushed expectations higher in the UK. Even the eurozone has witnessed a renewed vigour in its inflation readings.
In recent months, however, this trend has eased somewhat, as investors have grown sceptical that the Trump administration can push its legislative agenda through Congress.
This has resulted in a sell-off in inflation markets. However, the global inflationary backdrop is by no means homogenous and we see different trajectories for different inflation markets.
For active managers, this presents opportunities to add value both between and within individual markets. In our Absolute Return Global Bond Strategies portfolio, we are using the fund’s flexible mandate to exploit a number of areas that we currently view as mispriced.
Don’t rule out 'Trumpflation' yet
In the US, we believe the recent sell-off has created an opportunity. This is predicated on the view that the lapse into pessimism around ‘Trumpflation’ may be overdone.
A softening in trade rhetoric has shown that the Trump White House can be pragmatic and compromise; which could make for a smoother passage for future tax and fiscal policy legislation.
If we place this next to the USFederal Reserve’s dual growth and inflation mandate, which should mean continued support for the economy and only a gradual increase in rates, then we believe current inflation expectations are too low.
This is especially true of the long-end of the curve. Presently, the flatness of the curve reflects little confidence in the prospects for long-term inflation.
However, we think that as higher expectations become more ingrained and investors demand a higher term premium, the curve will steepen to reflect this.
Furthermore, relative to the short-end, the long-end has moved too far in response to the latest leg-down in oil, given the short-end’s greater sensitivity to price shocks.
In anticipation of this, we are positioned to benefit from a steepening in the curve between the five and 30-year areas.
Brexit pushes inflation higher; but for how long?
Meanwhile, the political backdrop has also influenced the trajectory of inflation in the UK.
The Brexit vote triggered a sharp depreciation in sterling that has propelled inflation to multi-year highs, a move that received further impetus from Trump’s victory.
For now, investors are pricing for inflation to remain at these elevated levels over the medium-term.
However, we believe that the effects of the currency depreciation will wash out of the inflation numbers in the next couple of years.
Furthermore, increased price pressures are likely to suppress real wages and economic growth. This makes the sustainability of inflation at current levels over the medium-term questionable.
Because of this, we hold an outright short position in UK inflation, particularly in the three to six year part of the curve.
We are also positioned for a steepening in the five to 10 year part of the UK RPI curve, as some of the steam comes out of current five-year pricing.
These trades are good examples of the opportunities that exist in today’s highly nuanced inflation market − a backdrop that looks set to continue.
For now, the US exhibits the most sustainable inflationary impulse, whereas in the UK the effects of Brexit will continue to put pressure on inflation from both directions in the short-term.
In Europe, we believe the outlook is more subdued; the European Central Bank’s April minutes lamented the limited evidence of inflationary pressures.
As the last 12 months prove, however, much can change in a short space of time – which means flexibility will be critical if investors are to capture opportunities as and when they arise.
Amit Moudgil is an absolute return fixed income investment specialist at Standard Life Investments.
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