In this video, the Co-Heads of Strategic Fixed Income, John Pattullo and Jenna Barnard, share their assessment of the impact of rising inflation expectations in developed markets and whether higher inflation will take root. Despite the general market assumptions for higher inflation in the developed world, the team expect interesting opportunities in government bond markets in the coming months.
How have rising inflation expectations impacted sovereign bonds globally? What about credit spreads?
Year to date, bond yields have broadly risen across the world; a mixture of rising inflation expectations and real yields rising a little bit as well. That is not really a great surprise to us, given the synchronised global uptick in growth and activity, which is quite encouraging, but which is pretty much late-cycle. So, the US Federal Reserve (Fed) continues to raise interest rates at the short end, pulling up rates at the front end, and less so as you move down the curve.
Credit spreads have generally widened. They performed quite well in January as sovereign bonds sold off — as you would expect, just mathematically — and then generally faded into February and March. US investment grade was probably the weakest. High yield was reasonably resilient as it has a decent coupon and a shorter duration (lower interest rate sensitivity) and so outperformed on a relative basis. More generally, credit has widened with the rise in sovereign bond yields, which is fairly unusual.
Are developed markets at the beginning of a regime shift with regards to inflation?
The inflation narrative is very specific to the US. Recent inflation data in most countries (in the past few months), whether in the UK, Europe or Australia, have actually been ‘in-line’ or ‘slightly disappointing’, and do not show the late-cycle inflation narrative seen in the US. It must be remembered that even in the US they have undershot their ‘core’ inflation target pretty much the entire business cycle, which goes back nearly ten years now. So, we think some context needs to be given: a little bit of late-cycle inflation in the US (having undershot) — yes; a bigger regime shift in inflation — no; we are not seeing it at present. We think people are over-extrapolating what is going on, late in the cycle, in the US.
We do expect inflation to rise a little bit in the next couple of months, especially headline inflation on the back of oil prices. Core inflation will rise a little bit, but it would probably peak in the autumn and could come down with base effects and perhaps the oil price coming off. However, we do not think that core inflation is going to rise materially. We both feel that the markets are confusing the sort of inflation they are seeing with some structural breakout. But we have to worry about other people worrying about headline inflation, which we think will peak quite soon, and that is quite exciting for us as a bond managers going forwards.
Where are you finding the best bond opportunities now that developed market central banks have started to raise benchmark rates?
We have started seeing the global convergence trade and theme — the idea that other central banks would hike rates and catch up with the Fed — unravel since January. The Australian central bank was very clear that they are not participating in this rate rising cycle at the moment. The Bank of England have had to backtrack a little bit on the interest rate hiking cycle that they started last November and Bank of Canada have actually turned a little bit more dovish. We have seen economic growth become more desynchronised in recent months, and the story is very different to the one at the back end of last year.
As for opportunities, we added duration via government bonds in Australia, Canada, Sweden and Germany in February after the January sell-off. We are managing duration tactically and staying nimble, as it is late-cycle and we believe bond yields are in the process of topping in various economies, but that can be quite a choppy process. The big opportunity this year for us is to extend duration meaningfully — even in the US — but we are not at that point yet and we have to be patient. Thus, at the moment we are playing it through a theme of divergence — different economies at different spots in the economic cycle.