Inflation: villain or hero?

Inflation is back with a vengeance after years in hiding. Is it here to stay? 

 Should we fear it, or could it be a force for good?

 And is it kryptonite for bond investors? 

 In episode 6 of our Fixed Income TEAMTALK podcast, Fixed Income Investment Specialist Peter Marsland and his fearless team of inflation watchers answer all these questions and more. 

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Transcript

Peter Marsland:  Welcome to abrdn’s Fixed Income TEAMTALK. I'm your host, Peter Marsland, Fixed Income Investment Specialist. And today we'll be discussing inflation.

I'm joined by Adam Skerry, Head of Inflation, Andrew Stanners, Investment Director within our Emerging Market Debt Team, and Roger Webb, Deputy Head of Sterling Investment Grade and Aggregate. Welcome everyone, and thank you for your time today.

As regular TEAMTALK listeners will know, we like to kick it off with something non-investment related. Almost grabbing the headlines as much as inflation, has been the latest Spider Man film, without doubt my favourite superhero. So that got me thinking – who is your favourite superhero? And let's start that with Roger.

Roger:  Ah - cheers Peter. Mine is probably a little bit of a controversial one, because he's not one of the conventional superheroes, I'd go for Deadpool – Deadpool is obviously the Ryan Reynolds movies. And controversially, I actually quite liked Ryan Reynolds himself. So the movies for me are funny, he's a self-deprecating character. It's a great action movie, it’s got a love story in there as well. So it's all the ingredients for me to make it my favourite superhero, or anti-superhero, if you like, as well. 

Peter: Great choice. And to you Adam. 

Adam: I'm going to have to swing it back a little bit to economics, I'm afraid, Pete, and sort of lower the tone slightly. But given that I'm relatively optimistic on the outlook for the US in this coming year, so you know, real GDP should be around about 4% on the back of around about five and a half in 2021 I think I'm going to have to go for Captain America. 

Peter: Ha-ha. Very good. Very good. And you, Andrew?

Andrew: So I've got a five-month old - you may hear in the background, hopefully not. So my superhero will be Pingu at the moment. They seem to be saving the day with their little TV shows. But I did come up with an obscure choice to rival Adam’s, which is Dr. Brian Braddock, who I'm sure you're all very familiar with. He is Captain Britain, a 1970s comic book hero that is not on the movie set yet. But clearly, there's an opportunity for someone to step into these boots. But his major power, though, is to uphold British law, which clearly in these COVID times appears to be someone we need. But we'll see whether that ever makes it to the movie screens but a bit of an obscure one for you there.

Peter: Very good, sounds like Captain Brexit if he’s after upholding UK law - that's a very interesting choice. Well, thank you for that. That's, that's food for thought I'm sure. 

Now back to today's topic of inflation. And Adam, you may recall that we discussed the inflation dilemma in a previous  TEAMTALK in mid-2021. And since then, US CPI has hit 6.8% year on year in November, which is the highest it's been since 1982. And Eurozone CPI hit a record high of around four and a half percent. So how long can we expect this level of inflation to continue within developed markets? 

Adam: Yeah, thanks, Pete. What a great segue to bring in a 1970s UK superhero to bring in the inflation topic. So yeah, yeah, as you say, I mean, the inflation prints have continued since our last conversation to reach ever higher highs. So, the peak is probably going to be hitting Europe around about now - so kind of late 2021, early 22 around about that 5% level that headline - US slightly later, so January, February, around 7%. UK slightly later again, so Q2, we expect to CPI to hit around 5.2, 5.3%. So obviously, those numbers are well above the central bank targets.

We do expect them to come down. So there is an element of base effects in there and some of the things that have been grabbing headlines. So some of the anecdotal evidence that we're getting is around some of the supply bottlenecks starting to ease slightly. So things like the transportation issues, whether that be shipping or trucks getting stuff delivered to where it needs to be, companies adjusting their output to suit the specific end-user demands, technological changes that increase productivity - these things are starting to kind of ease to help the inflation bottlenecks that we were seeing. 

But these aren't going to happen overnight. So we do expect them to persist for most of this forthcoming year, there will be issues, there will be kind of glitches along the way that mean, we don't get, you know, a completely return back to normal, if you like, in terms of the supply side. 

What kind of stands out more to us, is the kind of investors that we are and the more sort of longer term themes, the structural drivers that we look at, and not so much about whether semiconductors can get delivered, you know, in this sort of ‘just in time’ sort of framework, but it's more about the supply side of the economy in terms of the labour market, and the impact that has upon headline inflation and the core inflation that underlies that. 

So for example, in, in the US, we're looking very much at trends, such as the demographic trends, so we're seeing a very, very tight labour market at the moment, which is feeding through into higher wage demands, into higher rents, into higher housing costs, that we feel are actually structural, that we feel that some of these trends were in place before the pandemic actually hit. So when we look at those kind of trends, we look at things like, the baby boomers retiring, being taken out of the labour force, the reduction of net migration - so this is a kind of global phenomenon, this isn't just specific to the US, we are seeing these kind of drivers actually leading to higher structural inflation. So we do feel that there will be a return back towards Central Bank targets. We don't think that. you know, we're in this world of persistently higher inflation at these kind of levels, but it likely is going to be around for some time to come that is going to be sticky for the time being.

One other element to touch on quickly, because again, it has been getting a lot of headlines is on the commodity side. So headline inflation has been driven to a large extent by this kind of commodity story underlying it. So whether that be the oil price, whether that be natural gas, we expect that volatility to continue to as the economies reopen, both on the demand and the supply side, we expect some disruption. 

So we do think that the commodity story will be here again, for some time to come, both surprising to the upside and the downside, potentially. But what we don't think is that we're entering some kind of commodity super cycle, we don't think that this is a kind of persistently higher inflationary environment driven by commodities, for the medium to longer term. 

And just while we're on that, just probably with our kind of ESG hat on for one moment, one thing that is going to be a story for years to come, if not decades to come, is going to be this shift away from fossil fuels to decarbonisation story, which is getting embedded more and more in the infrastructure plans and the fiscal plans of governments. So, the amount of spending, potentially trillions and trillions of dollars for years to come, could have an impact on the inflationary outlook. So it's one to bear in mind, but as I say, a very sort of long term theme to consider. 

Peter: Yeah, I think that ESG angle, as you mentioned, it's going to be quite an interesting development to watch. So that's the picture across developed markets, just turning to emerging markets - Andrew, is it a similar picture in the regions that you focus on?

Andrew: Yeah, it's you know, within the food and drink, is a very big component of most CPI baskets around about a third in some countries. So what happens to some of these soft commodities will be pretty influential in terms of inflation outcome. Now within EM, I would say it's kind of a different world to DM. Inflation never died for us. We've, we've always had inflation is certainly quite high in some countries, even whilst developed markets have experienced this wonderful period of low inflation. So in a way, it's, it's kind of helped this general global rise of inflation, because a lot of the central banks within the EM have reacted pretty proactively. And they've started their hiking cycle, well in advance of the Fed and other DM central banks. So this has put them in a much better position, but in general, I would probably characterise EM more regionally. So for Asia - maybe if you ex out China - growth is expected to be strong or maybe even stronger than last year. But China itself clearly is starting to look like it's adopting a more accommodative approach and stance. So with that in mind, inflation expectations are flat, maybe a touch lower this year in the Asian region. 

But conversely, when we look at EMEA, central banks have been reacting – albeit from a low base. And, and we are seeing, you know, and expecting growth to moderate a little bit there. So we expect inflation to start falling back as the year progresses. 

Where it looks most pronounced is the Latam region. We've seen very big hikes in a number of countries there. And that really has and will have a big impact on growth. If you take Brazil, for example, Q3 and Q2 have negative growth. So a technical recession last year, interest rates are relatively high market is pricing in a lot of those hikes, if not too many. And as a result, growth is looking like it's going to be relatively sluggish in that region this year. So probably you're looking at much lower inflation coming down, similar to what Adam mentioned, you know, around Q1/Q2, this year, so it's very different across the regions, but there are definitely some opportunities appearing, in particular in LataAm. 

Peter: Yeah, I think it's fascinating. You mentioned the differing picture between emerging market regions, and I guess that's probably similar to how high inflation can impact corporate sectors and different companies, Roger. 

Roger: Yeah, certainly, Peter. I suppose the big issue for us for a period of time now has been supply and demand and in the credit market generally. So I'll start off by just talking about credit as an asset class and then move into sectors and the impact within sectors. 

The asset class has benefited, obviously, from huge demand over the last few years, negative real yields that we've already mentioned, have been the glue that have held markets together. And credit specifically has been supported by those negative real yields as investors go and search something, something more positive than the opportunities available in other asset classes. So that demand continues, and it's been - it will remain the case for the time being, it has been the case for the last few years as I've said. 

I suppose the big risk going forward is that central banks seem to lose control or inflation is more even more persistent than it has been, which would create volatility and therefore have a knock-on impact on to risk assets like corporate bonds.

Given that spreads are relatively tight at the moment, there's not an awful lot of room for manoeuvre there. So  all eyes on that, but as I say, the market for the time being appears to be reacting fairly benignly to what has been a significant period of, or a significant pickup in volatility and inflation with prints. 

I suppose specifically - and back to your question - some areas are more directly impacted naturally by inflation prints than others. I think the inability to pass through higher input costs is more of an equity issue than a credit quality issue. That doesn't mean that companies aren't impacted, companies that we invest in are naturally impacted. But credit quality doesn't deteriorate aggressively, just because we have a few quarters of more negative earnings because of those inflationary issues. There are naturally sectors like energy, healthcare, which are broadly speaking not massively impacted by inflation, whereas other sectors, industrials, consumer facing industries do have bigger challenges, undoubtedly. 

So it's not to say I discount the impact on sectors and we are seeing some dispersion in performance within credit sectors or investment grade corporate bond sectors, but it's not material enough to cause concern at the moment. Where you do see, you've got low pricing power, and that's to say the inability to pass prices through in sectors like the auto parts, telecom equipment sectors, that's where it's very difficult for those companies to pass on the impact of hiring and put prices to their customers. And those sectors are obviously the sectors that just been impacted most severely by supply chain impacts from the pandemic. So there's potentially one to watch for the time being. But from my perspective, I think  we're more likely to see opportunities coming out as a result of underperformance in those sort of sectors than we are to be to be more concerned about credit quality over time. 

We'd normally also look at tech and telcos to be not hugely impacted. But then again, as you as you've seen in the last few weeks, you do see the impact of potentially higher policy rates, which have been priced in by markets, impacting the tech sector quite aggressively in terms of equity valuations, and that happens more than others. 

And I suppose I should finish by reiterating a position that we've had for some time now which is one of the big beneficiaries of higher yields, which do come from higher inflation potentially and steeper curves, is obviously the financial sector. And that's banks and insurers, that would be probably the biggest beneficiaries in our universe from higher yields and deeper curves. So, we still prefer financials to non-financials.

And I’ll probably finish on potentially one of the bigger risks for corporate bonds and credit in 2022, which is related, is the potential for increased leveraged transactions, obviously, yields are still relatively low, the cost of funding is relatively low. There's an awful lot of private equity money around, and the economic environment that's been created over the last couple of years in particular, and even with the inflation prints that we're seeing, creates an environment where sort of private equity and M&A activity generally may be encouraged. And that's, that's potentially a risk for corporate bonds going forward, more than, the inflationary risks - the inflationary headline risks that we're talking about today.

Peter: Thanks, Roger. And you touched on a couple of things there around sort of central banks reacting to this picture. I mean, given their inflation targets, it's the sort of natural other side of the coin, is how central banks will react to inflationary pressure, either as well, inflationary pressure on the upside, and the downside, I guess. 

So, turning to you, Adam. I mean, what's your view about how central banks have actually been reacting? Or they've been reacting quickly enough to the inflationary pressure that we've seen? And what's the likely path that they're going to take from here?

Adam: Yeah, thanks Pete. I mean, I've got some sympathy with their position, I mean, through 2020 and 2021, we need to remember the degree of uncertainty that was there.

So when we first hit the pandemic, and through, you know, the subsequent period, there's so much uncertainty there that I think they're always going to toe that line of being slightly more cautious than sort of just specifically looking at their mandated targets of inflation and or the labour market. So, you know, we have to remember that there was an unprecedented size of stimulus thrown at these developed market economies. So you know, both on the fiscal and the monetary side, that wasn't going to necessarily have an impact overnight, particular on the monetary side. So they had to let it breathe and see what actually transpired. 

And the picture now is hopefully slightly more optimistic on the kind of robustness of these developed market economies. COVID is obviously still a huge uncertainty. But I think now we can start to look at some of those kind of structural issues that I mentioned before, in terms of the inflationary impact, and the central banks can start to home in on those slightly more, as I say, I mean, they had the transitory and the flexible average inflation targeting and you know, these other kind of justifications for keeping policy looser than perhaps the mandates will otherwise suggest that they should have. But as I say, I think that was justified. 

But we've seen in late 2021, coming into the start of 22, the majority of central banks in the developed markets started to push back against that more and more. So the transitory rhetoric that was given by the US Fed has now been dropped. And we've seen the dot plot start to reflect that, in terms of, you know, the rate hike projections and the withdrawal of quantitative easing, potentially quantitative tightening in the not too distant future, which when you look at the inflation backdrop, the employment backdrop, you look at the economic data that's been coming out more recently, you can see why that is starting to happen, you can see why they're looking to tackle inflation more head on than they have done during the pandemic. 

So I think you know, that that is here to stay. And I think that that movement towards a tighter policy regime is going to be a big story for the forthcoming year. But there will be huge differentiations between those developed market central banks. So I don't think it's a one size fits all different. Central banks reacted in different ways. And the recovery will be different across Europe compared to the US compared to the UK and other developed markets.

So we've already seen the UK, the Bank of England at the end of last year, put a hike through so that was the first hike that we've seen post-pandemic. The US are making more and more noises about the first hike. So current pricing has around three hikes priced for 2022. But the ECB is slightly more cautious. So you know Lagarde’s saying that, you know, rate hikes are very unlikely in the near term. So they are still assessing it and to be honest, that is probably justified by the fact that their inflation problem coming into the pandemic was more to the downside than the upside. So I think that if we do return to something that looks slightly more normal, then you can understand why the ECB would take that stance. 

But it's just to say, we will probably get, you know, a fairly divergent range of views from the central banks. Each of them has got their own inflation problems to tackle, the labour market and the reaction to the pandemic, in terms of how governments and central banks reacted to their each individual labour market problems will require different responses subsequently. So, you know, so far, it seems at the end of the furlough scheme in the UK, and the end of the job support schemes in the US haven't led to huge spikes in unemployment. So as I mentioned before, the US labour market in particular, looks very tight. So if that remains the case, you could potentially see the Fed get increasingly hawkish, because there are just less reasons to, you know, stick with this ultra, ultra-loose policy. 

But again, we have to kind of caveat that with, you know, the degree of uncertainty that's there. I mean, it wasn't that long ago that we were mentioning stagflation, which is the kind of nightmare scenario for all central banks in terms of you've got inflation running well above target. But the economic picture, and the growth outlook looking very, very benign, if not negative. 

If we do start to move back towards that kind of scenario, then I could see the central bank starting to kind of, again, sort of move back towards the more sort of dovish end of the spectrum, compared to what we've heard in more recent months. 

Peter: Yeah, interesting you mentioned there the effects of the Fed hiking rates and moving into a cycle of higher levels of interest rates there. I mean, turning to you, Andrew, from the developed market picture to how that might influence an emerging market picture. Are you concerned about the sort of second order effects of the Fed increasing bank rate? 

Andrew: The question kind of reminds me a little bit - you're all very young, but I'm comfortably middle aged - it reminds me a bit of the kind of conversations you have with your doctor, where the doctor will tell you that your cholesterol is quite high, you need to look at it. Comparing cholesterol to inflation here - so you'll have to bear with me if this analogy is pathetic. 

But there are two types of cholesterol broadly, there's good and bad. The conversations I have with my doctor, are very similar to the conversations we've been having within the markets for the last nine months. Is this good or bad inflation, you know, and initially, that the transient nature of it implied it was good inflation, so supply side bottlenecks, etc, not feeding through into the demand side wage pressures that force central banks to act more aggressively. 

So I guess linking it back - very tenuously - is, you know, it really will depend on, on whether this inflation really does morph aggressively into wage and demand side, or whether a lot of it does dissipate as bottlenecks are removed. And I think the market is getting increasingly concerned that we're moving to bad inflation from a Fixed Income point of view. But it's still not decided fully yet. So I think there's still a lot of flex in how the Fed reacts as the year goes on. 

In terms of the second order effects, clearly, if it is bad inflation, if I can term it that, then there is a reasonable amount of expectation that leads to a dollar strength environment, reasonable amount of risk-off mentality, both in equities, and I guess in the riskier perceived segments of Fixed Income. So yeah, this would be a difficult or challenging environment for us. 

Historically, and there aren't many periods which have - obviously QE in play - but historically, the markets price relatively quickly and aggressively Fed hiking cycles, and that affects EM in particular, but after that, normally EM does relatively well as the hiking cycle starts to go into its mid-cycle of hikes. So we're at that first stage now you see increasing volatility, a little bit of uncertainty in the markets in EM. But as we move more into a fully established hiking cycle, our markets can do okay, so it's a mixed bag. But yeah, initially, definitely, you've got to be slightly concerned about your position – and your cholesterol.

Peter: Yeah, well, thank you for bringing that sort of medical aspect to TEAMTALK. I think that's a first actually, so thank you for that - that's good. And actually just leading on from that, if we were in a good inflation environment, I guess that might have some positive aspects for emerging market economies where they'll see the commodity prices increase, and that could actually improve some of their sort of GDP output. 

Andrew: Yeah, definitely. Uh, you know, if you look at, if you look at some of the oil exporters in the Middle East and Africa, you know, their budgets for oil are $45 to $65. If oil stays here, then fiscal position is going to look much, much stronger, they're not going to have to make fiscal cuts, expenditure cuts. So the growth dynamic can look a lot better in, in a number of these economies. So yeah.

It's not clear at the moment, clearly, that bad environment would be initially challenging for EM. But after that, there are definitely some opportunities available. And if it's good inflation, as you say, then there are opportunities already here and available.

Peter: And talking about opportunities within sort of the Fixed Income universe, I mean, it's a common held conception - could be a misconception - that inflation is not necessarily good news for conventional or nominal bond prices, given that it has an erosion effect on the value of the cash flows that bonds provide, you know, almost like the kryptonite to Superman, if you like. 

Peter: Focusing now on your universe, Adam, which is all inflation linked assets, I guess they'll become expensive? Or do you see opportunities where you can add some relative value? 

Adam: That’s a very subjective term Pete - ‘expensive’, but value is in the eye of the beholder. But yeah, I mean, from a, sort of fundamental perspective, we want to bring it back to kind of basic valuations if you like, I mean, if we look at where central bank targets are, relative to break-evens, then if you look at long data break-even, so for example, in the US 30 year breaks are around 2.3%. So that is effectively saying that the Fed are going to be successful in bringing inflation back. And it's going to be a relatively benign inflation outlook for the long term. So nothing to see here really. 

Similarly, in Europe, I mean, 25 year break-evens in the cash market are around 2%. So again, a kind of environment where the market is not saying inflation is going to persist for any significant amount of time, really. So if you do feel that we are in a structurally higher inflation environment, that we have moved away from the Great Moderation, as it's known, of the last 30 to 35 years, of inflation being relatively benign, you know, the kind of issues that we faced back in the 70s, and the postwar period

behind us, then fine. But I think if you if you want to hedge your inflation for the long term, then break-even still offers some degree of value.

The other end of the curve, so the shorter end of the inflation curve is much more aggressively priced. So when we look at something like the five year RPI swap in the UK, that's priced at 4.4%. So that saying that on average, for the next five years, RPI is going to be around about four and a half percent in the UK. Now, that is significantly above the Bank of England target, and it's effectively saying that the inflation issue in the UK is one that will stick around for the medium term. Further out, the curve kind of levels off slightly. But it is saying that, you know, the UK is facing potentially a greater inflationary problem than elsewhere in the world. 

So I would say that is kind of fully priced in terms of, you know, if you wanted to hedge your inflation outlook, that is priced for the upside scenario, whereas the kind of more longer dated inflation products that we look at in particular, whether that'd be in index-linked bonds or inflation swaps are for the US and Europe in particular, saying that, you know, inflation is going to dissipate in the medium to long term. And there's nothing to see here. So, for us that offers value, we think that, you know, if we do enter this environment where inflation does stick around for longer, that there should be more term premium, if you want to call it that,. So that's where we've focused most of our long exposure is towards the longer end of the curves. And we don't feel that even if central banks do get slightly more hawkish in the near term, that you're going to be hit that hard at that back-end, because you're not pricing a particularly high inflation environment to start with, as opposed to the front end. 

Peter: So it's important to look across your global universe to appreciate what's going on.

Adam:  Yeah, exactly. 

Peter: And across the maturity spectrum as well. 

Adam: Yeah, and that gives us, you know, kind of relative value opportunities, given that, you know, the majority of the money that we run, and the portfolios on offer are global in nature, that it gives us that diversification benefit. 

So if we do see a kind of dislocation in one market compared to another that we feel offers some kind of asymmetry, then we can look to play that and you know, we've got the full universe of doing that through duration, doing that through curve, doing that through inflation derivatives. So we do have that kind of opportunity set to take advantage of those dislocations globally.

Peter: Yeah, I think that's  a really good point to finish on, I think, a flexible approach either within pure inflation linked products or across the Fixed Income universe where you're trying to build a portfolio for the environment that we're in currently, is absolutely key. And I think that'll be crucial as we go through 2022.

I think that concludes this episode of abrdn Fixed Income TEAMTALK and I'd like to thank our guest speakers for their heroic contributions. Thank you very much, everyone. 

And if you'd like to find out more about our latest Fixed Income views, you can subscribe to our Fixed Income newsletter by clicking on the link below. You can also listen to previous TEAMTALK podcasts again by clicking on the link below. And finally, thank you for listening and goodbye.

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