13 January 2020
Inflation across most regions has started to accelerate over the past few weeks. The recent conflict between the US and Iran, on Iraqi soil, has also put pressure on oil prices. While the situation is still fluid, the sentiment driving markets recently, and the underlying dynamics, are well worth monitoring.
State Street Global Advisors does not anticipate an overshoot in inflation, but it is one of the risks, or grey swans, that remains on investors’ minds. Meanwhile, institutional investors have not necessarily favoured US TIPS lately, continuing a long-term trend. ETF flows for inflation-linked exposures were also somewhat unimpressive in 2019, with just $2.7 billion of inflows when fixed income ETFs gathered more than $260 billion in total.1
Are investors underestimating the risk of an upside surprise? PriceStats® suggests that US inflation was unseasonably robust across the fourth quarter. Coupled with 2018’s collapse in energy prices dropping out of the inflation calculation, this has prompted an abrupt turnaround in the annual inflation rate. Headline and core inflation rates will now converge above 2%, begging the question for the first half of 2020 of whether they will remain below 2.5%.
The main elements in favour of higher US inflation include:
- Oil prices holding up, leading to a continuation of the base effect in energy in Q1 2020.
- Average hourly earnings remain above 3% against a 50-year low in unemployment rate (U3 at 3.5%). This could support current core CPI levels between 2.3% and 2.4%.
- Technical support due to low expected issuance in Q1 2020 especially in the 5- and 30-year space.
- A positive macroeconomic story for the US in Q1 2020 as the consumer holds.
- Dollar weakness driving import prices higher.
Beyond Middle Eastern tensions and potential domestic US political headline risk, progress on phase one trade deal has partially removed trade war risk and lifted breakevens. Nevertheless, it remains a risk to this more positive picture. We should highlight the more tactical nature of this “positive” inflation story as anticipations for headline CPI beyond Q1 2020 are far less optimistic.
How can investors navigate this theme? US TIPS (Treasury Inflation-Protected Securities)
As the recent backdrop has become more supportive for TIPS, and the risk-on mood has helped relative to nominal treasuries, the trend could potentially hold further for a relative value trade in Q1 2020, as illustrated in the chart below.
There are various ways to get exposure to inflation protection, and the duration profiles of indices have an impact on the magnitude of the performance deviation. Another option is to favour short-dated corporate bond exposures and to reduce duration and the indirect negative effect that inflation risk brings with it – higher nominal yields and the ensuing interest risk.