1. Inflation Expectations – Too Much Too Soon?
The period since the surprise election of Donald Trump as the 45th President of the United States has been characterised by a significant increase in inflation expectations, at least compared to the previous six months. Much of this increase seems to stem from a belief that there will be a shift from monetary stimulus to fiscal stimulus in the U.S., which could then be copied in other major economies. But it’s worth stepping back a bit from the noise and analysing some of the major economies in isolation, rather than grouping them all together. In the U.S., President-elect Trump still has a lot of work to do to get his fiscal stimulus programme enacted. However, the legacy of the Obama healthcare price increases and year-on-year effects means it is likely that the U.S. headline inflation rate could accelerate north of 2.5% in Q1 2017. This will probably happen at the same time as the unemployment rate continues to gradually fall towards 4.5%, and may stoke fears that the Fed is indeed happy to let the economy “run hot” for a period. Against that backdrop, U.S. inflation-linked bonds continue, in our opinion to offer decent value. On the other hand, over in the UK, inflation breakevens (the gap between the sovereign bond nominal yield and the sovereign inflation-protected bond yield) have already risen substantially, and are already discounting a significant rise in UK inflation. The recent depreciation in the UK currency means there could likely be a short-term spike in UK inflation, but in our view UK domestic economic conditions over the next 12-24 months may not be conducive to a sustained pick-up in inflation. Therefore, we’d be less positive on UK inflation-linked securities. In Europe, the situation is a bit more mixed. We anticipate a short-term spike in Euro-area inflation towards 1.5% in Q1 2017, but then it should fall towards 1% over the remainder of the year (assuming the oil price stays around its current level). Although Euro-area inflation breakevens haven’t rallied as much as their U.S. or UK counterparts, they still look, in our opinion, closer to fair value. One area that does, in our opinion, look good value, however, is the very long-end of the Euro inflation curve. 30-year Euro-area inflation linked bonds still project that inflation will remain below 2% for the next 30 years, something we think is probably too pessimistic.
2. UK – Calm Before the Storm?
We are often asked why the UK economy has performed so well in the aftermath of the unexpected Brexit vote, when all forecasts predicted that the economy would sink into recession if the UK voted to leave the EU. In our opinion, there are two reasons. Firstly, nothing has really happened yet in terms of actually leaving the EU, and nothing should happen until Article 50 is triggered by UK Prime Minister Theresa May, likely to take place in March 2017. So for the ordinary UK citizen, including those who run businesses, life hasn’t changed – yet. Secondly, the significant depreciation in the British Pound has given a short-term boost to UK exporters, and possibly allowed them to increase their market share in European and U.S. markets. But there are a few warning signs on the horizon that things, at the margin, might be about to change. As I sit here eating my Brexit-affected Toblerone, and ponder the news that the size of Malteser bags are to be reduced by 15%, I note that the overall price of materials and fuels bought by UK manufacturers for processing rose 12.2% in the year to October 2016, compared with a rise of 7.3% in the year to September 2016. Between September and October, total input prices rose by a record 4.6%, compared with an increase of 0.1% the previous month. In simple terms, raw materials are getting more expensive, and that will impact overall price levels. Secondly, according to the Bank of England’s Agents survey, the demand for credit from small and medium-sized businesses is beginning to stagnate. The suggestion is that Brexit-related uncertainty is causing businesses to postpone investment decisions, with knock-on effects on hiring of labour. Finally, there were reports last week from two respectable media outlets that the UK government is in disarray about its Brexit strategy. Speculation about the possibility of a snap 2017 election is growing, and could be reinforced if the government’s appeal to the Supreme Court concerning the triggering of Article 50 is rejected. We continue to believe that an underweight position in UK sovereign bonds is warranted.
3. Italian Government Bonds – Short-Term Caution Warranted
We believe investors should consider reducing any overweight Italian sovereign bond position after the U.S. election result. In our minds, the election of President Trump could potentially signal a significant change in the outlook for global bond markets, and by extension, for Italian government bonds. As we noted above, Trump’s election signalled to us that fiscal stimulus programmes could be a viable alternative to the limitation of what central banks can do. But fiscal stimulus packages are usually debt-financed, and initially cause an increase in the debt/GDP ratio of a sovereign. Given Italy is starting from a very high debt/GDP ratio of 135%, this is a concern for markets. Secondly, there is the issue that the boost to economic growth from stimulus packages tends to only last for about 2 years before fading, so there is no guarantee that the boost to growth will be permanent. Finally, there is the issue of the Italian referendum on electoral reform, due to be held on 4th December. Polls have consistently shown that the referendum may be defeated, which raises concerns about political stability in Italy. There is still uncertainty about whether Prime Minister Renzi will resign or not if the reforms are defeated, but the markets are clearly in favour of him staying regardless of the referendum outcome. Prior to the Trump election, we felt that the 10-year Italian/German yield spread was in a range of +100bps/+150bps. As markets were pricing in a “NO” vote in the referendum, the spread had moved to the upper-end of that range. However, the election of Trump has led to a sell-off in global bond yields, with significant under-performance from the riskier areas of fixed income, such as peripheral European bond yields. Consequently, we believe the 10-year Italian/German yield spread range has moved higher, probably into a +150bps/+200bps range. We suggest investors hold a neutral position in Italian government bonds, but should probably look to increase that position to an Overweight in the event of a significant further widening in spreads. It’s worth remembering that the ECB will probably act as a backstop in such an event, by increasing purchases of Italian government bonds in its bond-buying programme.