Inflation is a complex phenomenon. Often self-fulfilling, it tends to become stronger when economic agents believe that it is present. This makes it difficult to forecast - so central bankers have largely been wrong in recent years. After having overestimated it, it is clear that inflation has been significantly underestimated in recent months in the United States and Europe.
As Karl Otto Pöhl, President of the Bundesbank in 1980 said so well, "inflation is like toothpaste: once it's out, you can hardly get it back in again. So the best thing is not to squeeze too hard on the tube". In light of the latest figures, it seems that the monetary and fiscal authorities have pressed the tube a little too hard.
Of course, inflation will fall, simply through the base effect. But how far? Returning below 2%, which has been the norm for 10 years, or towards 3%, is not at all the same thing for the markets and even less so for economic players. Today, the market expects inflation to return to around 3% in the United States by the end of 2023. At Candriam, our central scenario anticipates a significant risk of higher inflation.
What is the basis of this reading? There are three points to the answer:
inflation is based on several long-term factors:
- Fiscal and monetary stimulus. First, the structural change of central banks towards a more symmetrical inflation target following their strategic review. While the restoration of inflation was the ambition of the central banks a few years ago, clearly the target now appears to be met, or even exceeded. Massive liquidity injections combined with fiscal stimulus have been a major contributor to the inflationary environment. With unemployment rates at their lowest and ageing demographics, the risk of wage renegotiations could continue to fuel the inflationary spiral.
- Supply chains, which have been under strain since well before Covid. Already present under Donald Trump's presidency and the rise in trade tensions with China in particular, deglobalisation has been accentuated by the Covid "effect”, and this movement looks set to continue unabated. Combined with climate change, the risk of a food crisis could have a more lasting impact on inflation forecasts.
- The cost of the energy transition: some financiers call this "greenflation". Companies need to invest heavily in the ecological transition: costs are very high and rising. To build a wind turbine of 3 megawatts, for example, 2 tons of rare earth, 3 tonnes of aluminium, 3.5 tonnes of copper and 335 tonnes of steel are required! This demand will structurally weigh on the cost of commodities, and the energy transition could also impact the medium-term inflation outlook.
So what are the solutions for the investor?
The best way to combat this inflation in a bond portfolio is to reduce its sensitivity to interest rates and be ultra-selective. Among the fixed income instruments most suited to such an environment, in our portfolios, we favour:
- Floating rate bonds: their coupon, reset periodically on the basis of a benchmark rate (the three-month interbank rate) plus a credit spread determined by the market, offers natural protection against rising interest rates; Today, an average credit premium of nearly 120 basis points is realistic. If we consider that short rates exceed 1%, such a strategy could pay off. Moreover, the evolution of floating rate bonds is negatively correlated with the yield on sovereign bonds. They thus offer a good diversification opportunity for a bond portfolio.
- Inflation-linked bonds, with a preference for the short end of the curve. With inflation figures expected to continue to exceed expectations in Europe over the coming months, and inflationary pressures increasing (commodity prices, deglobalisation, supply chain issues, etc.) inflation-linked bonds are an attractive investment vehicle to protect against the risk of inflation surprises. After the recent drop in inflation expectations, we believe they are a relevant alternative to nominal bonds, especially on the short end of the curve. The inflation that we will see accumulating in the coming months thus offers a significant protection against a rise in real rates.
Long-term challenges are huge and will have a lasting impact on inflation while generating volatility. It is therefore important to properly prepare portfolios. These more unstable times are likely to give credibility to flexible, active and responsible management. It is up to us to give investors the opportunity to take full advantage of this
Main risks associated with the use of floating rate bonds and inflation-linked bonds:
- Risk of capital loss
- Interest rate risk
- Credit risk
- Counterparty risk
- Risk related to currency
- Liquidity risk
