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Our views 08 February 2021

JP's Journal: The outlook for inflation

5 min read

One of the headlines in the Times on Saturday was “Mining giant strikes gold as it takes FTSE crown”. This got me thinking: despite the performance of tech, the importance of pharmaceuticals and the size of financial services, the single largest company quoted on the London Stock Exchange is a commodity producer whose share price has doubled since March 2020. Is this telling us something about future inflation?

Actually, there is an interesting contrast here with the media coverage of the Bank of England’s (BoE's) report on negative Bank Rate. On Thursday there was increased chat about how negative rates could be implemented and how the BoE was taking steps to add this to their tool kit. How can we reconcile the market possibly looking for higher inflation and increased discussion of negative interest rates?

Well I think we can – because the BoE was actually sounding quite optimistic on the outlook, with a return to pre pandemic growth by Q1 2022. Our Rates team thinks the BoE is pushing back on utilising negative rates inside the next six months. The BoE now expects inflation to rise sharply towards the 2% target in the spring (due to VAT and energy prices effects) and that inflation will be close to 2% over 2022 and 2023. They added that they now see the risk to their forecasts as balanced, rather than to the downside, despite revising down their Q1 GDP forecast to -4%QoQ.

I have said that I am not an inflation bear but that investors should seek out prudential inflation protection where it is reasonably priced. The big unknown is how consumers will react to better times ahead. What we have seen is a massive shift between public and private debt: governments have increased spending (proactively and through welfare spending) while consumers have increased cautionary savings. At the moment price rises are reflecting supply issues – disruptions caused by Covid. What we may see later in the year is demand-induced inflation as consumers, freed from the shackles of lockdowns, start spending again. Normally, government will react through fiscal policies and tighter monetary policy. But government and central banks may both be reluctant to tighten too soon. Short-dated strategies in global index linked bonds look sensible.

Cash, government and currencies

Again 3 Month GBP LIBOR edged a bit higher to just above 0.04% while the US rate moved lower to below 0.2%. Sterling was stronger for choice at 1.374 USD and 1.14 EUR.

Ten-year US rates rose to 1.17% and this increase was matched in most markets. The exception was in Italy where the Draghi effect pushed yields lower. The spread between German and Italian ten-year debt narrowed to 0.9%, a move which generally helped our funds. Real yields moved higher but implied inflation rose in all markets.

The UK gilt market was especially volatile in the week with ten-year yields ending at 0.48%, the highest since the spike in March last year. The yield curve also steepened sharply in response to the MPC minutes which indicated that the trigger level where QE could start to be unwound may have to move lower with the introduction of negative rates to the toolkit. This saw ultra-long UK yields rise by 18bps on the week – representing a price decline of over 6%.

The Rates team view is that is that the front end of the gilt market still needs to cheapen up – perhaps another 10 to 15bps – and that this is likely to result in pushing ten-year yields a bit higher with further yield curve steepening. We retain a duration preference to be below benchmark.

Sterling Credit

Credit yields rose in the week – but this reflected higher gilt yields. Spreads declined by 3-4 bps with significant demand across the curve, especially at shorter maturities. There was another Green Bond issue – this time a two tranche offering from Whitbread. Initial price talk attracted a massive book, which still largely remained despite spreads tightening by over 30 bps. The bonds tightened further in the secondary market, showing strong demand for sterling bonds with a spread of over 2%.

My preference remains for subordinated financial debt and asset backed / secured bonds (I can hear you saying: what’s new) but see little obvious value in generic sterling credit.

Global Credit

Higher government bonds yields impacted global investment grade as well – but not high yield where indices moved up. My favoured measure of high yield saw spreads tighten by 20 bps, moving decisively below the 4% mark.

Our funds bought into a new issue from Petsmart, a privately held American chain of pet superstore. The BB- bonds was sized at $1.2bn and issued with a spread 4% and has traded well in the secondary.

The theme of higher commodity prices was also reflected in oil where Brent moved up to $60. This will help some of the more distressed part of the debt market.

Ending on the theme of inflation – I think our short dated high yield strategies also fall into the category of protecting against inflation. From my perspective a combination of cash, short dated global index linked bonds and short duration credit bonds looks better value than long dated index linked.

For professional clients only, not suitable for retail investors.

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.