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Opportunities amid inflation and high valuations

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Developed market (DM) bonds performed well over the summer months despite stronger growth and inflation, plus lower yields also provided a tailwind for risk assets. However, GAM Investments’ Adrian Owens believes inflation is likely to prove more than temporary indicating the outlook for DM bonds could become challenging. He gives his thoughts on how to navigate such an environment.

16 September 2021

Summer bond rally was positive for risk assets

Supportive central bank comments and concerns over the spread of the Delta variant of Covid-19 saw both risk assets and sovereign bonds perform well over the summer months. In July, the European Central Bank (ECB) helped markets when officials provided a dovish update on their forward guidance. In August, Federal Reserve (Fed) Governor Jerome Powell’s Jackson Hole speech was viewed as supportive given Powell downplayed inflation fears and the connection between tapering and future rate hikes.

In our view, bond markets have become expensive following recent moves, as shown by the record lows in European real rates. Although as Chart 1 and Chart 2 demonstrate nominal rates have retreated materially from their end-March levels, this has been driven by falling real rates rather than inflation expectations on both sides of the Atlantic.

Charts 1 and 2: Nominal US and European rates have fallen of late, but inflation fears remain

Source: GAM. Data from 1 June 2020 to 6 September 2021. Past performance is not a reliable indicator of future results or current or future trends. For illustrative purposes only.

But the case for marginally higher yields in the run up to year end is growing

As Governor Powell acknowledged during his aforementioned speech, the US recovery has been faster than the Fed expected. Inflation, too, has been above both Fed and ECB forecasts. It is also proving to be less temporary than anticipated. Labour shortages are apparent in multiple surveys, from the Job Openings and Labor Turnover Survey (JOLTS) to the Institute for Supply Management (ISM). Supply constraints have shown little sign of easing despite economies opening up.

US inflation measures are generally running above 4% and the headline Consumer Price Index (CPI) reading is as high as 5.3%. Perhaps more worrying is the continued rise of pipeline pressures. US producer output price inflation (factory gate inflation) is running at 7.8% and core (ex-food and energy) producer output price inflation is 6.2%. The single most important measure of pipeline inflation pressures, however, is wages and most of these measures are around the 4% level.

Within ‘low inflation’ Europe price pressures are also on the rise. The August Flash CPI measure for the eurozone came in at 3.0% with Germany as high as 3.4%. Growth and inflation dynamics are not consistent with the current level of interest rates, and given recent rises in equity markets and declines in bond yields, policy conditions have loosened further. That said, central banks are largely dictating where they want rates to be via their quantitative easing programmes. During the summer, the volume of official bond buying relative to new supply was no doubt a major contributor to the bond rally; our expectation is that this dynamic will become less supportive in the coming months.

Chart 3: Bond valuations already expensive

Source: Deutsche Bank, Haver Analytics, the Commodity Futures Trading Commission (CFTC), US Treasury. As of 6 September 2021. Past performance is not a reliable indicator of future results or current or future trends. For illustrative purposes only.

Some objective valuation metrics suggest DM bond markets are expensive. Chart 3 shows the relationship between 10-year Treasuries, short-term policy rates and market positioning; the ratio between bond issuance and supply illustrates the point. More traditional valuation metrics that include inflation and growth show markets are far more stretched.

What does this mean for markets?

The case for DM bonds remains poor, in our view. Fundamentals (activity and inflation), valuations, supply / demand dynamics, positioning (speculative Commodity Trading Advisors (CTA) positioning has gone from short to neutral) and the fact Covid-19 levels appear to be plateauing are all headwinds to consider in the coming months. Risk markets have performed well and we continue to believe that opportunities remain, but if we are right on the outlook for bonds the coming months could be more challenging. If, as we expect, inflation continues to prove more than temporary the rhetoric around tapering is only going in one direction. We believe investors would likely benefit from spreading risk further into alternatives that can perform in a more challenging environment for traditional assets.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not a reliable indicator of future results or current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented and are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. There is no guarantee that forecasts will be realised.

Adrian Owens

Investment Director

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