Market expectations of inflation have been rising in recent weeks as the war in Ukraine disrupts energy and food supplies. Core inflation, which strips out commodity prices, had already been climbing in the wake of the pandemic, unsettling central bankers. As fears of higher inflation mount, index-linked bonds would seem to be the natural solution. So why are we backing away from our holding in US Treasury inflation-protected securities (TIPS)?
Ben Seager-Scott, Head of Multi-Asset Funds at Tilney Smith & Williamson, the leading wealth management and professional services group which is set to re-brand to Evelyn Partners in the summer, comments:
The first problem is that the trajectory of inflation from here is not clear. While the war in Ukraine appears likely to send energy prices higher in the short term, it is very difficult to judge the medium or longer-term outcome. Analysts have warned that oil prices could reach US$200 per barrel in a worst-case scenario, but at the same time, the International Energy Agency has already highlighted a number of countries are ready to release more oil. The Agency agreed to release 60 million barrels of oil from its emergency reserves to ensure there will be no shortfall in supplies as a result of Russia’s invasion of Ukraine.
Equally, the outcome of the war itself is extremely difficult to predict. It is plausible that peace talks bring about a compromise, which might soften the oil price shock and relax some of the inflation jitters. If, on the other hand, there was a deterioration in the crisis, its effects on global economic growth could be profound. If the conflict spreads, declining economic growth could dampen inflation.
Against this backdrop, rising inflation is still a possible scenario, but not assured. As such, we need to look at what the market is assuming about inflation. The price for direct inflation-protected assets such as inflation-linked bonds will reflect inflation expectations rather than absolute levels of inflation. If high inflation is already anticipated by the market, they won’t provide a lot of protection.
For inflation-linked bonds to make progress, inflation would have to run higher than expected not just for a few months, but for the longer term. The benchmark we use for TIPS has a duration around eight years. While market expectations for short-term inflation have spiked higher in recent weeks as the Ukrainian crisis has escalated, longer-term expectations remain relatively stable. Energy prices already reflect some of the moves that US, UK and Europe are making in terms of restricting energy exports from Russia. In other words, markets already reflect the most likely outcome for inflation.
When building our asset allocation, we look at a range of scenarios and aim for balance. Today, we don’t believe there is much to support an ongoing position in inflation-linked bonds, given the balance of probabilities. Inflation expectations are relatively high, which caps any upside. We initiated these positions in mid-to-late 2020 when inflation expectations were low and they have done a good job for our investors, especially against core government bond, but now looks like an appropriate time to exit given the significant revision in those expectations.
At the same time, markets aren’t pricing in any significant slowdown in the interest rate hiking cycle. The era in which central banks intervene aggressively to calm market nerves is over, we believe. While there is a scenario in which central banks would defer rate rises to ease the cost of living squeeze, hoping for any permanent pause in the rate hiking cycle is wishful thinking. Rate expectations have dipped in response to the crisis but are rapidly reverting to their previous level.
Commodities would be the other option for inflation-hedging. These tend to do well in a scenario where input cost inflation is rising, but fare relatively badly in most other scenarios. As such, we would need strong conviction that inflation was going to continue rising, which we don’t. Equally, a holding in commodities would mean cutting back on our equity exposure, which may be a better option in today’s environment.
Having moved away from inflation-linked bonds, we are flexible in how we deploy that capital. Areas such as short-dated credit and short-dated gilts are starting to look attractive and we have to be ready to move quickly when they hit our targets. For the time being, we are holding tactical cash, with the aim of moving quickly when the opportunities emerge.
To hedge against an escalation in the conflict, we still have ‘risk-off’ insurance from our weighting in gold. Gold has recently broken through the US$2,000 per ounce barrier and we expect it will continue to perform well through this crisis. On the other hand, if we do see a market recovery, holding meaningful equity exposure will be vitally important. We believe that equities still offer significant protection against inflationary pressures over the medium term.
Investors need to be wary about rushing for the obvious inflation trades. At times when inflation expectations are already high, they can become very crowded trades and often won’t provide the protection investors hope as a result. We are remaining agile in our positioning in the face of considerable uncertainty.