In the latest video from the Strategic Fixed Income team, Jenna Barnard explains how many investors are convinced of a regime shift in inflation and the impact it has had in the bond markets.
- Bond markets are yet again trading on shifts in “narratives” rather than “fundamentals.”
- Core inflation has been remarkably stable across developed economies since the late 1990s and will likely remain low because of a number of long-term, structural factors.
- Investors need to be patient for the latest bout of volatility to burn out when good investment opportunities should surface.
Your browser must support iframes to play this content.
I was keen to update investors on our thoughts on the bond market. The first thing I should say is that John Pattullo and I do not buy into the regime shift narrative on inflation in developed economies. Government bond markets do tend to trade on these shifts in belief and narratives rather than shifts in fundamentals, but core CPI has been remarkably stable across developed economies since the late 1990s. We get periodic bouts of hysteria about inflation or in deflation, but beneath the surface, core inflation we think is responding or remaining low because of many structural factors that we have discussed in the past.
However, having said that, we are respectful when markets do trade these narratives and coming into 2018, government bond yield curves were very flat, particularly in the U.S. and credit spreads were quite tight. And that combination of valuations made it difficult for bond investors to see a path to making good capital returns. However, following this repricing in both of those markets, we are now seeing more opportunity, particularly because we don’t believe that U.S. core inflation is going to pick up this year, because of the way of shelter and rent within those measures. Those cycles have turned down, they tend to be quite persistent when they do turn, and for that reason it is going to be very difficult to get a core inflation regime shift in the U.S. and indeed many other markets.
So following the repricing, where are we seeing opportunities? Well, first I would say at the very front end of government bond yield curves. We have seen some interesting rate hikes priced into markets, 100 basis points in Canada, where the housing market is turning down, where household debt is extremely high. I mean they have already had 75 basis points of rate hikes in the last six or seven months. The UK’s pricing in about 75 basis points of rate hikes over the next two years. Europe, it is about 40, Australia is 55 basis points, despite the central bank there pushing back against the rate hiking global narrative, because of low inflation and low wage inflation. And as I said, a lot of repricing has been done at very short-dated government bond yields. In terms of longer-dated government bond yields, this kind of hysteria, we have to be patient and pragmatic and wait for it to burn itself out. We think the economic data will turn down from around April globally, based on the lead indicators we look at. But we think a lot of the hard work in terms of repricing and valuations have been done.
So from that perspective, I would say that at present we haven’t seen much real information that would change our longer-term view of investing in bond markets. Most inflation data in the developed world is continuing to come in inline or perhaps even a little disappointing this year in the case of Australia and Sweden. But we remain respectful of these kinds of sharp repricings, these volatility shocks in government bond markets that we have seen periodically over the last five or seven years. So eventually, as this thing burns out, it will be a great investing opportunity from our perspective, but we need to be, as I said, patient and pragmatic and wait for these yield curves to steepen up a little bit and/or credit spreads to widen.