Inflation has in many ways been the dog that didn’t bark of the past four years.
As central banks cranked up the printing presses and began to buy government paper by the tonne, many predicted Weimar-esque erosion of monetary value and the imminent introduction of million-dollar bills.
In a US election year, the Republican party has adopted a policy platform commitment to consider a return to the gold standard.
At fiscally conservative rallies, Federal Reserve chairman Ben Bernanke is almost as unpopular as Barack Obama.
And yet US inflation is well inside the inflation-targeting mandate. The UK arguably has a structural problem of sustained inflation, but the absolute rate remains at a level that would have been considered enviable through many periods of British history, well under the rate of the early 1990s, let alone the soaraway 1970s.
That the apocalyptic warnings have not yet come to pass does not make them wrong, however: it merely means they have not yet become right.
In a period in which central bank boards freely admit they have little to no precedent for the ‘unconventional’ policies they are pursuing, no one can say with any certainty what the ultimate impact of quantitative easing (QE) and other stimulus will be.
‘The name of the game is financial repression,’ says Enzo Puntillo, Citywire A-rated manager of the Julius Baer BF Total Return fund. ‘If you go back to World War II, it took 20 years for inflation to emerge; these things can take a very long time.’
So what’s the best way to protect fixed-income portfolios against the long-term, worst-case inflationary scenarios?
Puntillo turns that question round and says the most urgent question is less about how to protect against an exceptional inflationary event, but what to do about the largest and most liquid Western sovereign issues trading well below a break-even reversionary rate of real return. ‘Every year you are holding gilts, bunds or Treasuries you are losing something like 3%,’ he says.
Moving into short positions
For this reason, Puntillo has moved as much as 40% of net assets into short positions against leading Western sovereigns in the last month. As speculation about QE3 mounted in mid-August and mid-September, yields on the ‘safe haven’ sovereigns moved out by as much as 30%, although this has since tightened a little.
‘Some of these fat tails are now backed by central banks, and people are moving out as they realise the risks they are running,’ he says. ‘We are not looking to protect against inflation in the short term, but where we can find cheap protection against the future, over a 20 or 30-year horizon. Bernanke has made it clear now that he is basically prepared to keep on printing forever.’
To him, the problem of protecting against a foreseeable future of moderate inflation and a longer term horizon with little-to-no visibility on inflationary prospects is fairly simple.
‘We have added Israel and Poland [recently] at yields of around 10%,’ he says. ‘You are getting high real yields and very cheap inflation priced in.’ Up to 30% of the portfolio is currently invested in emerging market local currency debt.’
On the latter point, much depends on your expectations for global growth over the next 12 to 18 months, however.
Capital Economics, one of a very few forecasters to accurately call the sustained low in Treasury yields, has short-term yields pencilled in at a rate of 1.5% for the foreseeable future, on the back of continued global deleverage and structurally limited growth prospects.
The Macro Research Bureau (MRB), however – which has a much more bullish forecast for growth on expectations of a stimulus-led recovery in risk assets – believes the long-term trend has begun to break down decisively.
But both agree the market will remain volatile and continue to move with the pendulum swing of risk on and risk off.
‘While nominal yields have risen modestly in the past three months, real yields have drifted deeper into negative territory,’ noted MRB in recent guidance to clients.
‘Thus, the rise in nominal yields was a result of higher inflation expectations, in anticipation of, and then in response to, the Fed’s QE3 announcement last month (inflation expectations are already pulling back). Consequently, Treasury returns have stalled in recent months, which we interpret as a signal that the underlying uptrend is no longer intact.
‘That said, in the short term, G7 government bonds should be well supported. Economic data will continue to be soft over the balance of the year, and inflation expectations are biased downward after their recent rise.
‘Looking out six to 12 months, we expect G7 government bond yields to gradually drift higher as global growth prospects improve. Upward pressure will principally come through higher real yields, as recession/deflation fears slowly are unwound.
‘The flip-side is that the Fed and other central banks are committed to keeping short-term interest rates low for an extended period, and would combat any material rise in longer-term yields unless it were driven by a marked improvement in the economic outlook.’
In contrast to Capital Economics, MRB has a medium-term, two-year treasury yield target of 2.5%, which would imply a 4% loss on current pricing. In terms of inflation protection, the company’s bullishness has led it into a high-risk, high-volatility strategic overweight recommendation on Spanish and Italian debt, which at a current trading range of near 6% it believes will only be consolidated as the European Central Bank delivers on its pledge to save the union.
The volatility of inflation expectations has been a key opportunity for Cheviot’s chief investment officer Alan McIntosh.
Having run an underweight position in fixed interest for almost all of the last few years and exiting his inflation-protected gilt holdings in 2011 on pricing concerns, McIntosh says the recent moderation in pricing is close to the point at which he could be tempted back into a significant allocation.
‘At the moment linkers look very attractive relative to regular gilts on a valuation basis,’ he says. ‘But their pricing will be changed by the [government’s proposed] change to RPI [from a CPI benchmark] and we need more visibility on how that will change how they are valued.’
His caution is echoed by Capital Economics, which has calculated the government’s planned shift in how inflation benchmarking is calculated will wipe more than 1% off long-term yields, with inflation-protected gilt holders the biggest prospective losers under the new methodology.
Reforming the picture
The picture is complicated slightly by a 2005 change to gilt contracts, with holders of securities issued earlier than this entitled to redeem them at current values. More recent issues have no such security.
‘Existing index-linked holders look set to be the biggest losers from the successful implementation of the proposed reforms,’ notes Capital Economics’ Samuel Tombs.
‘Both coupon payments and the redemption value of index-linked gilts depend on RPI inflation. So a lower rate for RPI inflation would cause index-linked gilts to be worth less [in nominal terms] than they otherwise would have been.
‘If the reforms are passed, then the market price of index-linked gilts would fall, causing real yields to rise,’ he adds.
‘That said, market prices may already reflect the risk that these inflation reforms are passed. For example, 10-year index-linked gilt yields rose by five basis points after the announcement of the consultation on RPI reform on 18 September.’
MRB adds that even from a fundamental basis, it is hard to locate much value in either inflation-linked gilts or treasury inflation protected securities, however.
‘With any upward pressure on nominal yields in the next year likely to come predominantly via real yields, inflation-protected securities will underperform conventional government bonds.
‘Despite more aggressive monetary policy support from major central banks, the need for inflation-protection is minimal on a six to 12-month horizon.’
Puntillo says he is finding good opportunities in longer-dated Latin American local currency index-linked sovereigns however, as inflationary expectations yo-yoed. In particular, he said he had been adding to his holdings of Mexican index-linked debt. ‘Brazil is offering 4%, Mexico at the long end you are getting 2.5% to 3% and Chile 4% real yield,’ he adds.
‘There are in effect two positives – the real yield and a good rationale that at some point down the line inflation will begin to pop up in these countries. Mexico we like [particularly] at the long end – curves are very steep and you get to lock in a large real yield [for cheap].’
Latin America currently faces a tricky balancing act between domestic economies offering little room for rate tightening, and external sources of domestic inflation, such as food prices, that are putting the squeeze on households.
On recent levels of agricultural product inflation, following poor weather and drought this summer, regional inflation is expected to rise from 4.7% to 5.5% by early 2013.
Any substantial improvement in risk appetite would also risk a return to the speculative capital flows that have impacted on domestic pricing in recent years. Having launched currency controls on 2010, Brazil lifted them this year.