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ARTICLE

TIME TO RETHINK INFLATION-LINKED BONDS?

By Raffaele Prencipe,
Fixed Income Portfolio Manager DPAM

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WHAT CAUSED THE CURRENT BOUT OF INFLATION?

The unprecedented events of 2020 will be etched in our collective memory for years to come. As the COVID-19 pandemic uprooted our daily lives, we were left reeling from the effects of prolonged lockdowns and subsequent supply chain disruptions. The global economy suffered a massive setback, with the supply of goods and services plummeting. However, the fiscal policies adopted by governments worldwide and loose monetary policies resulted in a surge in aggregate demand. The excess demand over supply created a ripple effect, leading to an unprecedented rise in prices. Central banks in the developed world opted not to intervene, as inflation had remained low for decades.

Fast forward to 2022, and another shock hit the global economy. The conflict between Russia and Ukraine led to a curtailment of the supply of essential commodities like grains, oil, and gas. This resulted in an unprecedented rise in the prices of these commodities. While fiscal policy remained expansionary, monetary policy became restrictive to curtail the inflationary pressures. Global financial conditions were also adversely impacted, resulting in a more challenging economic climate.

Figure 1: Central Banks – Policy Rates

Source: Bloomberg, 31 January 2023

IS THE INFLATION PROBLEM OVER?

Headline inflation is showing signs of decreasing. Over the next few months, we can expect to see a further decline in inflation as the clearing of inventories of goods and energy help to bring it down. However, the path towards economic stability is never a straight line. Recent developments, such as the lower gas prices in Europe and the reduction in gasoline/petrol prices in the US, have led to increased demand and an improvement in financial conditions. In the medium term, it is uncertain how long the phenomenon of “revenge spending” will last, and whether the labour market will start to weaken. These factors will play a pivotal role in shaping the trajectory of the global economy in the medium term.

Figure 2: Core Inflation Year over Year

Source: Bloomberg, 31 January 2023

In the long term, many anticipate a return to a state of low inflation, growth, productivity, and interest rates. However, there are several factors that could pose an upside risk. The trend towards de-globalisation, for example, may cause a rise in the costs of supply of goods. Similarly, the ongoing green transition may increase demand and impact inflation rates. Central banks may also choose to increase their inflation targets from the current 2% to 3%, and this could have significant ramifications.

A change in psychology may occur, too. It is important to remember that inflation is the result of the decisions made by billions of economic actors. Their decisions are influenced by their expectations of future inflation, and these expectations can often be irrational.

ARE INFLATION-LINKED BONDS OF ANY USE NOW?

The difference between nominal and real yields has become a barometer of inflation expectations – also known as ‘breakevens’. Despite the recent surge in inflation, market players continue to believe that central banks will eventually meet their 2% targets. Indeed, 5-year breakevens in both the US and Eurozone have not exceeded 3.8%. This seems to be a significant underestimate when compared to an average increase in Consumer Price Indices (CPI) of over 7% in the last 18 months.

Figure 3: Break-evens 10Y

Source: Bloomberg, 31 January 2023

Inflation-linked bonds outperform nominal bonds when realised inflation is higher than the breakeven at the time of purchase. Purchasing a 5-year US linker on 1st January 2021 has resulted in a total return above 0%, as opposed to ≈ -9% for a 5-year nominal bond. The return on inflation-linked bonds is based on their real yield, along with the future accrual of CPI on principal and coupon.

Both real and nominal yields have significantly increased. Although breakevens usually move lower during the contraction phase of an economic cycle, 2.2 and 2.3% for 10-year linkers could still be an underestimate. In conclusion, even with the worst behind us, inflation-linked bonds can play a role for protection of a fixed income portfolio.

DISCLAIMER

Degroof Petercam Asset Management SA/NV l rue Guimard 18, 1040 Brussels, Belgium l RPM/RPR Brussels l TVA BE 0886 223 276 l

© Degroof Petercam Asset Management SA/NV, 2022, all rights reserved. This document may not be distributed to retail investors and its use is exclusively restricted to professional investors. This document may not be reproduced, duplicated, disseminated, stored in an automated data file, disclosed, in whole or in part or distributed to other persons, in any form or by any means whatsoever, without the prior written consent of Degroof Petercam Asset Management (“DPAM”). Having access to this document does not transfer the proprietary rights whatsoever nor does it transfer title and ownership rights. The information in this document, the rights therein and legal protections with respect thereto remain exclusively with DPAM.

DPAM is the author of the present document. Although this document and its content were prepared with due care and are based on sources and/or third party data providers which DPAM deems reliable, they are provided ‘as is’ without any warranty of any kind, either express or implied. Neither DPAM nor it sources and third party data providers guarantee the correctness, the completeness, reliability, timeliness, availability, merchantability, or fitness for a particular purpose.

The provided information herein must be considered as having a general nature and does not, under any circumstances, intend to be tailored to your personal situation. Its content does not represent investment advice, nor does it constitute an offer, solicitation, recommendation or invitation to buy, sell, subscribe to or execute any other transaction with financial instruments including but not limited to shares, bonds and units in collective investment undertakings. This document is not aimed to investors from a jurisdiction where such an offer, solicitation, recommendation or invitation would be illegal.

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Investing incurs risks. Past performances do not guarantee future results. All opinions and financial estimates in this document are a reflection of the situation at issuance and are subject to amendments without notice. Changed market circumstance may render the opinions and statements in this document incorrect.

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