In principle, inflation is bad for bonds. The fixed value of bond interest payments and principal is eroded in real terms as inflation rises. However, bond markets have proved efficient and quickly discounted the higher inflation regime. Bond investors are now compensated with higher yields. If
inflation were to peak, as we think it will, this would be a big boon for bonds.
Inflation across many economies remains at multi-decade highs. The question is, however, what can drive it higher? Our answer is not much. The supply shock and the resultant higher commodity prices are largely responsible for the price pressures we are seeing. While wage growth does have the ability to feed through into more persistent inflation, nowhere is wage growth keeping pace with goods inflation. This will eventually lead to lower aggregate demand.
The initial resilience of consumers to higher prices might have something to do with their dipping into the savings buffer accumulated through the pandemic. This can only be a temporary solution. At some point, people will have to tighten their purse strings. Signs of waning consumer demand are emerging in some countries, for instance the UK – an economy particularly vulnerable to imported inflation.
There is more uncertainty on the supply side of inflation, but for base effects to work – a fall in the year-on-year level of inflation – we just need to see spot (or realised) inflation stabilise. We are already seeing inflation expectations plateau and inflation measures beginning to surprise to the downside.
Breakeven inflation rates (the difference between nominal and real bond yields) are a good measure of the market’s expectations for inflation. They are starting to roll over as the chart below shows.
Could the market continue to re-price higher inflation and further rate hikes?
It can be uncomfortable going against the market consensus, but by doing so, investors are able to achieve the best possible return potential. Markets are efficient and can quickly move to price in the market or consensus view.
The past has shown that the point of maximum fear has often been the point of maximum opportunity. The chart below shows the percentage return made on an allocation to the Global Aggregate bond index at the low point of previous drawdowns.
Yields are at the most attractive levels for several years. And the income that bonds generate should provide a buffer – or at least some leeway – if yields move higher or credit spreads widen further.
Importantly, global bond markets are now providing attractive all-in total return potential: price gain plus income. The market level mean that bonds offer more scope to protect from capital losses should yields rise further, certainly more so than over the past five years.
Three reasons bonds are back
1. Valuations are attractive following the sharp drawdown, current levels offer attractive total return potential. Even if we are wrong in the short-term and bond yields continue to rise, the increased level of income provide a higher protection to capital loss than we have seen for some time.
2. Given broader global uncertainties around future economic growth global bonds can be a good diversifier as part of a broader portfolio. Indeed, global aggregate by its very nature is also a diverse way to allocate to bonds. The Bloomberg Barclays Global Aggregate index has exposure to over 40 sovereign markets and 20 country issuers of credit.
3. There is increasing evidence that slower global growth will mean that some of the rate hikes assumed by bond market pricing won’t be realised, particularly as it looks likely that inflation is peaking, if not has already peaked. Given the speed of the market move, we truly believe this
has opened up a number of very attractive opportunities. It is for these reasons that bonds are back in focus.