Despite improving fundamentals for the global economy, fixed-income investors should not ignore warnings from economists and asset managers about inflation lest they end up paying the price for complacency.
Fears of an uptick in inflation have gripped the market in the past week amid worries that central banks, led by the US Federal Reserve, are considering a shift in their existing low interest rate policy in order to soften the impact of the massive amounts of fiscal stimulus being pumped into the financial system, particularly in the United States and the European Union. The US stimulus is US$1.9 trillion while the EU is injecting around US$2.2 trillion.
The vaccine rollout, while a positive development in terms of controlling the virus and boosting economic recovery, may aggravate inflationary pressures that will adversely affect the performance of fixed-income assets.
In a note to investors issued last week, Goldman Sachs Asset Management sounded reassuring, saying that real yields have trended higher, albeit from low levels.
“For investors, the driver behind the rise is important. If higher real yields reflect an improved growth outlook (due to additional US fiscal stimulus and encouraging vaccine progress), the impact on risk assets such as corporate credit and emerging market debt will likely be limited. If, however, the shift in real yields is driven by expectations for less accommodative monetary policy, the environment could turn less supportive for risk assets.”
Goldman Sachs argues that central banks will remain on an easy policy auto-pilot through 2021 and beyond because the underlying inflation reality is set to remain subdued (due to the slack in the labour market) and given a more tolerant approach to higher inflation outcomes (informed by prior inflation shortfalls and an increased focus on economic inequalities by policymakers).
Other asset managers, however, sound more alarmed in their language when making inflation warnings.
Paul Brain, head of fixed income at Newton Investment Management, an investment firm of BNY Mellon Investment Management, says: “Although coronavirus vaccines bring hope for control of the virus and boost markets as a whole, if this generates a rapid economic recovery this holds the potential to fuel inflation.”
Brain argues that throughout the pandemic, deflationary forces of the real economy have pushed against the inflationary influence of policymakers’ response. “The greatest danger going forward is that we experience inflation and policymakers are behind the curve in making necessary adjustments.”
This warning is echoed by Andrew Norelli, portfolio manager at J.P. Morgan Asset Management, who says: “For the first time in my career as a bond fund manager, I am concerned about a looming inflation narrative as the driver of a potential regime shift in financial markets and consumer behaviour. Normally I focus on downside macroeconomic threats, but the effectiveness of the 2020 policy responses against the economic hardships of Covid-19 leaves me with only one endgame, having agonized over it for months, inflation is the biggest risk to investors.”
In any case, César Pérez Ruiz, head of investments and chief investment officer at Pictet Wealth Management, says bonds are expected to face a more challenging time compared to equities in view of the increased inflation expectations.
“When it comes to impact on equities markets, the speed of rising bond yields is what matters, whereas absolute levels are significant for market multiples. That said, we are very positive on the earnings outlook for this year, but bearish on multiples and negative on bonds,” Ruiz says.