Keeping an eye on disinflationary forces

In the wake of the pandemic, we have seen extraordinary large-scale global monetary stimulus efforts and a change in the stance of major central banks away from inflation targeting and towards inflation averaging to boost growth. The question of whether these policies will stimulate inflation or not remains a hot topic for investors across the board. Our team is watching closely to understand how the global inflationary backdrop will evolve, positioning Fidelity’s multi asset income strategies in line with broad disinflationary views overall, while remaining alert to the risk of rising yields in the near-term. Indeed, we see a number of signs of disinflationary forces at play in the global economic picture, and these will be important to watch over the coming months.

One of the key signs of disinflation is the sizeable output gaps emerging around the world. The 7.5% gap between supply and demand in China, as well as other historically high output gaps, point towards too much excess supply for businesses to be able to pass on sustainable price increases to consumers. The demand side also looks weak, and likely to remain so given ongoing low expectations for future income. Indeed, the wage inflation required for persistent inflation is hindered by weak employment data globally, even in Asia - the leader of the recovery so far. It is also difficult to see rising inflation coinciding with the credit contraction that we are seeing in some areas. For example, money supply in the US might be running high, but the velocity of money has collapsed with households using stimulus payments to pay down credit card debt and increase savings to an elevated personal savings rate of 2.5 times pre-Covid levels. US consumer credit card debt has contracted in five out of the past six months and credit card balances have reduced at an all-time high of 20% annualised rate. 

All these factors are reflected in concerning data. The recent Eurozone CPI of -0.2% was not only below expectations but was also deflationary (as opposed to just disinflationary) in direction, while inflation measures for China and emerging markets are at all-time lows. 

US real yields, 2-year market implied inflation breakeven and crude oil prices

^{Source: Fidelity International, Refinitiv Datastream. 17 September 2020.}

But shouldn’t liquidity, fiscal spending and the Fed’s average inflation targeting policy lead to more inflation? While it’s reasonable to assume in theory that credit growth should lead to inflation, our team sees that this link has been broken down since the 1980s. Inflation has mostly gone to financial asset prices and increasing inequality with it. For the real economy on the other hand, each round of QE brings with it an inflation expectation that only proves to be short-lived, leaving the rest of the economy still very much fighting disinflationary forces. The more asset prices become disconnected with the real economy, the more destabilising a spike in nominal or real yields may be. 

It’s clear that inflation (or disinflation) will remain front of mind over the coming months, but what does this really mean for income-seeking investors? Of course, inflation is a challenge to any income-seeking investment strategy. Given the extent of policy action we have seen, our team is cognisant of the risk of rising yields and some inflation in the medium term, and Fidelity’s multi asset income focused portfolios are positioned accordingly to insulate against this. Currently we maintain relatively low duration, both in terms of fixed income and equity sector real duration. For example, we are reducing our US investment grade corporate bond exposure as increased duration has made fundamentals less appealing. While we are mindful of the risk of an inflation-driven back-up in government bond yields, we are comfortable with taking duration risk on Chinese government bonds, which have shown their defensive qualities during the March lows this year, while offering an attractive yield pick-up over developed market government bonds. 

We have also been reducing exposure to leveraged loans and instead adding to high yield corporate bonds. Leveraged loans typically see inflows and outperform high yield bonds when Libor is rising or expected to rise. Current Fed policy may therefore render loans structural underperformers compared to high yield over the coming years, as Libor will likely be anchored to very low levels. Meanwhile, high yield credit has benefitted from the Fed backstop, resulting in a resilience over the past month against the equity volatility we have seen.

We’re now at an important inflection point where in practice, our team’s approach to thinking about disinflation is centred on having the conviction to act if and when yields rise, seeing this as a potential buying opportunity to add duration rather than a trigger to play a momentum sell-off in developed market rates. 

Overall, we believe that inflation will remain one of the most important stories for investors as we move through the rest of 2020. We are watching the global macroeconomic backdrop closely, continuing to draw on the analysis of Fidelity’s dedicated macro research team to understand its likely trajectory over the coming months. We believe it’s important to position income-focused strategies for a number of disinflationary forces while remaining flexible to adjust exposure in response to any changes in this unfolding picture.

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