The inflation preposition – a big shift?
Undoubtedly, rising inflation expectations had their fair share in negatively affecting spreads, with bond yields rising across the globe over recent months. To many market participants this comes to no surprise given the uptick in global growth and activity, supported by improving fundamentals. In fact, credit spreads widened with sovereign bonds heading the way, followed by investment grade bonds. Despite being on the same side of the story, high yield debt was more resilient as a result of having a more decent coupon and lower durations, thus lower sensitivity to interest rates.
In my view, inflation has to be taken in its geographical context, as over the past months we did see a divergence between inflation data in the US and Europe. In fact, looking at the latter’s inflation numbers those were in line as opposed to the inflation figures in the US which seem to be at the late cycle stage of the inflation narrative.
I think first and foremost it is important to distinguish between headline inflation and core inflation, with the latter being a stronger gauge of economic activity to which Central Banks give most importance. The difference between headline and core inflation is that the latter excludes energy and food prices. Thus when considering the fact that primarily energy prices were, are and will continue to be volatile, one should delve deeper into the inflation preposition.
In reality, we should experience slightly higher inflation figures mainly headline inflation primarily supported by higher oil prices. On the contrary, despite the recent increase, core inflation seems to be pursuing a more volatile path and in my view, we will not see any great shakes to the upside.
The major issue in financial markets vis-a-vis inflation is the confusion between the two forms of inflation. Central Banks are more inclined towards basing their monetary decisions on core inflation numbers, while markets tend to get excited on upticks in headline inflations. We have experienced this lately when the US 10-year bond breached the 3 percent level on higher inflation expectation, a movement that rattled the bond market.
As a bond fund manager, my worries are other people’s concerns, i.e. the initial reaction to headline inflation, and thus such worries will create more excitement amongst fixed-income managers, even based on my personal view that headline inflation will peak in the short-run.
The higher the expectations of inflation the more we will experience a rise in benchmark yields and such movements will trickle down investment grade bonds and then high yield debt. That said, given that core inflation should maintain a slower pace, possibly prompting the European Central Bank to delay interest rate hikes after August 2019, it might be wise at this point in time to increase the duration to pick-up yield.
In addition, given its historical resilience and the current low default rates, high yield might still be an attractive venue to generate returns. I believe at this point in time that it is more of a divergence play given that different economies are at different spots of the economic cycle. Let’s ride the roller-coaster of market excitement which is yet to come given both monetary and political themes which will continue to put pressure on financial markets, which however will also inevitably create opportunities.
Disclaimer: This article was issued by Jordan Portelli, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.