Target return: Generating real returns from bonds in a time of inflation

This advertorial will cover the following points:

• Tighter monetary policy and reduced fiscal stimulus will be offset by private-sector demand.
• Benign economic growth should support credit markets, particularly high yield.
• Long-dated government bonds are particularly exposed to a removal of liquidity by central banks and the end of quantitive easing.

The economic environment

The outlook for inflation remains an open-ended question

Prices will rise further over the coming months. The market suggests that RPI in the UK will hit 7.4 per cent in April-May. So irrespective of the long-term outlook, uncertainty about inflation will remain a live question.

Longer term, the transition towards a greener economy is likely to support inflation for years to come. Set against that, however, we are conscious that the disinflationary drivers (including demographics) that dominated the economy over the past few decades have not entirely disappeared.

On balance, our view is that the ‘landing zone’ for inflation will be higher than it has been over the past decade, during which the main concern was deflation. But we don’t think inflation is likely to become overly problematic. It is hard to foresee the world jumping directly from widespread ‘Japanification’ before Covid-19 to the sort of prolonged, high inflation we saw in the 1970s. A landing point somewhere in between seems likely.

We fundamentally disagree with worries about ‘stagflation’

The peak of inflation – not yet reached in many economies – is so high that it will require some time to fall back towards target. At the same time, all the signs are that economic growth is likely to remain healthy: so this is not ‘stagflation’.

Private sector demand will support growth

The biggest brake on growth will come from fiscal policy. Although most economies will continue running a meaningful fiscal deficit through 2022, the fiscal impulse will turn negative. But we believe this will be more than offset by the fundamental strength of the private sector.

In the corporate sector, the inventory cycle will be supportive: current stock levels are inadequate, particularly in the manufacturing sector. Investment will also increase – with automation likely to be a focus should wage pressures persist. In Europe, meanwhile, the Next Generation EU funds will continue to be distributed, supporting demand.

Restocking required: Inventory levels are extremely low

Consumers are in a strong position going into 2022

Pandemic-related restrictions on spending saw households increasing their savings and paying down debts. It is well known that excess savings have increased; what it is less discussed is that these savings (amounting to almost $4tn [£2.9tn] in the US) are largely sitting in cash and so can be rapidly deployed.

The strength of consumers’ financial position results from more than just savings: jobs are being created and wages are rising.

Household savings rate

Rising wages, especially for low-skilled jobs, should also support spending

In contrast to the period that followed the global financial crisis, wages for low-income workers have been increasing more rapidly than those for high-skilled jobs. This matters for aggregate demand: low-income workers tend to have a much higher propensity to spend.

US – Atlanta Fed wage growth tracker

The labour market will be crucial

If participation rates do not rise, the supply of labour will be insufficient to meet demand. This will trigger further increases in wages. If this is not accompanied by a parallel improvement in productivity, unit labour costs will increase. In that eventuality, central banks would have to respond much more forcefully than current market pricing reflects. This would be the key risk to our positive outlook.

A progressive withdrawal of monetary stimulus appears likely

Healthy economic activity and inflation that is well above central bank targets, in both developed and emerging economies, is creating a dynamic that is diametrically opposed to the one that has prevailed since the global financial crisis.

While monetary policy will tighten, we would argue that it is unlikely to stall growth. Policy will remain expansionary – just less so than it was in 2020-21.

Implications for bond markets

1: The macro environment we envisage should be supportive for credit spreads

Within the credit markets, high-yield is likely to perform better than investment-grade debt. It is less sensitive to higher rates and better able to withstand a period of elevated inflation. Robust growth, meanwhile, should ensure that defaults remain scarce.

2: Conditions seem likely to be challenging for government bonds

Interest-rate expectations in some economies now appear more reasonable than they once were. In the UK, for example, the market is now anticipating four-to-five rate hikes by the end of 2022. But the end point for interest rates implied in market pricing is, in our view, still too low. We think that long-dated tenors are particularly exposed to a removal of liquidity by central banks and an eventual end of QE.

The net supply of UK gilts is set to increase dramatically

3: We remain cautious on US Treasuries

We believe growth in the US economy has the potential to surprise to the upside in 2022. The labour market appears tight and inflationary pressures are broadening. So we are cautious on the US Treasury market, in both absolute and relative terms.

4: We retain a defensive approach in emerging markets

We have been short of emerging market bonds on several occasions over the past year. If our benign view of the path of economies proves wrong, emerging markets would be particularly vulnerable.

5: We are cautious on peripheral Eurozone bond markets

Economies such as Spain, Portugal or Greece would be very exposed to any removal of liquidity by the European Central Bank. Our short positions in peripheral European bond markets counterbalance our long positions in credit risk.

6: Valuations of inflation breakevens are too high in the UK

Ten-year inflation breakevens are trading close to 4 per cent, pricing in a very persistent overshoot of inflation relative to the Bank of England’s target. If inflation markets are correct, then nominal yields, especially in long tenors are too low. Therefore we are running short inflation positions relative to other jurisdictions such as Canada, where valuations are more reasonable, coupled with short positions in long gilts.

Juan Valenzuela is co-manager of the Artemis Target Return Bond Fund

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