by Dewi John.
Are investors divided over the likelihood of inflation or deflation? The Financial Times has argued that the “simultaneous fears of both inflation and deflation also help to explain the breadth of a rally this summer, which has taken in classic inflation hedges like gold as well as government bonds”.
It’s a harder market than ever to call. Post-global financial crisis hyper-loose monetary policy has failed to generate persistent inflation, despite the U.K.’s quantitative easing largess approaching three-quarters of a trillion pounds. If governments dig into their fiscal toolkits, this may have a greater—and more unpredictable—effect, so it’s anyone’s guess which way inflation breaks.
This issue is certainly something that’s preoccupying central bankers. European Central Bank (ECB) President Christine Lagarde has warned of persistent deflationary pressures, as the eurozone slipped into this territory in August. However, in April, J.P. Morgan Asset Management’s EMEA chief market strategist Karen Ward reckoned that “within a year, we will be looking at a very different picture”, driven by rising oil prices and the unfettering of demand once lockdown restrictions are lifted.
FT columnist Wolfgang Munchau also pitched in, pondering what all this posed for central bank rate policy. The problem, he said, was that “central bankers do not really understand how inflation works”. He added that, as far as the ECB is concerned, “a random number generator, a monkey with a dartboard, or even a horoscope would have outperformed” its inflation forecasts.
That may seem a tad unfair, but Munchau was echoing a 2017 speech by then chair of the Fed, Janet Yellen, where she highlighted “key…current uncertainties…driving inflation,” and conceded “that our framework for understanding inflation dynamics could be mis-specified in some fundamental way”. Which is quite a confession from someone who’s main job is to control inflation.
My mother didn’t raise any children dumb enough to go head-to-head with a dart-wielding lower primate, but I thought it would be interesting to see how investors were placing their bets on this question. If central bankers don’t know which way price levels will break, perhaps the wisdom of crowds in the form of asset markets can give us some insight.
Investors will reach for different tools, and so different asset classes, depending on what they see as the main threat.
Equities have often been a good long-term investment relative to inflation, as companies can raise prices. Higher prices translate into higher earnings. In addition, inflation helps to erode fixed costs, such as debt, so inflation is bad for bond holders. However, a large inflationary shock means firms are faced with input costs such as materials and wages spiralling out of control, and therefore harder to pass on as increased prices.
Conversely, deflation is bad for equities, as prices fall, squeezing margins. Deflationary assets include investment-grade bonds, defensive and higher-dividend stocks, and cash.
Where, then, are investors placing their money?
While there was a dash for cash in March, when everything sold off, investors were quick to put this to work in the months that followed. Money market funds have seen outflows of almost £2bn year to date, albeit with a partial reversal in September (£247m). This is noteworthy, as it’s accompanied by equity outflows (-£1.3bn) and bond inflows (£651m). You can interpret that either as a deflationary call, or growing risk-aversion, although the two aren’t mutually exclusive.
With regard to deflationary equity plays, U.K. investors are not exactly desperate for dividend-paying stocks, with those equity income funds that are attracting money generally having a lower than average yield. U.K. corporate bond funds lost £760m between February and September, with £355m of that in September alone.
So, while central bankers may be concerned about deflation, investors seem less bothered.
If inflation is a growing issue, one would expect to see increased allocations to equities and gold. In the bond world, this would mean shortened durations and shifts to inflation-linked debt.
But first we looked at all funds in appropriate Lipper inflation-linked bond classifications. Some of these are housed in the IA’s UK Index-Linked Gilt sector, but many are not classified by the body. Flows YTD for these funds were negative to the tune of £1.46bn, so not the most promising start.
Gold is seen as a good inflation hedge, especially when real rates are low. It’s been on an upward trend over the past two years, with ETCs being an increasingly popular way of accessing the yellow metal, but prices have dipped since August. And, while there have been modest inflows into U.K. gold funds in March and July—when we saw the largest equity outflows—these have been reversed in the following months.
While equity flows from January to August were in the black, despite a strongly negative June, we’ve seen that investors withdrew considerable funds in September, leaving equity flows negative (-£612m over the year).
With interest rates at historic lows, a small increase in prices would hit bond returns significantly. Investors wary of this could respond by either reducing their bond exposure or shortening their duration. Allocations to Lipper’s Bond GBP Short Term classification have gyrated around on a monthly basis this year—between negative £994m and £659m—but averaging to September, flows are a modest £83m. Sterling short duration flows are largely in line with broader bond flows over the year, with the exception being September, where the classification saw outflows of £462m.
Chart 1: UK Gilt and Index-linked gilt flows, 2015-2020 (£m)
Source: Refinitiv Lipper
Neither is there a clear signal in the relative flows to regular and index-linked Gilts (chart 1). Both sold off heavily in Q1 and, like corporates, have regained some but not all their ground since. Despite this, linkers have proportionately lagged vanilla gilts (down £295m v. £387 respectively, despite the U.K. Gilt sector being three-times the size), which doesn’t indicate investors frantically inflation-proofing their fixed-income portfolios by piling into linkers.
The other thing to look for with Gilts is the difference in yields between a Gilt—generally the 10-year—and its inflation-linked equivalent, known as the breakeven (chart 2). The bigger the number, the greater the market’s inflation expectation.
Chart 2: UK 10-Year Break-Even, Year to Date
Source: Refinitiv Eikon
While this has increased since the spring, when society stood on the brink of collapsing into a barter economy based on toilet rolls and dried pasta, break-evens remain below where they were in the second half of 2019, and have trended lower since mid-September.
That’s where the market is now. Current and historic flows can tell us a limited amount about where investors expect it to be next year. One indicator is what funds are being launched as asset managers jostle for pole position for anticipated investor demand, often responding to requests from their base.
For example, once economies got back into gear following the global financial crisis, all the cash that governments poured into markets sparked inflationary fears. Not a few firms saw wrestling matches between business development teams and portfolio managers. The former wanting to respond to investor demand and either shorten duration on existing portfolios or launch short-duration product, while the latter was often unconvinced by either the reality or the opportunity. Are we due to see this again?
There have been 63 bond fund launches so far this year. Seven of these are short duration. That’s quite significant and may indicate rising inflationary expectations.
Is this a house dividing over inflation or deflation? Judging from the above data, it’s a hard case to make. Rather than there being a strong bifurcation as some investors break for inflation protection while others look to deflation hedges, this seems to be a market that has grappled with immediate concerns since COVID-19 overtook us.
Investors have put the money they took off the table up to February back to work, which is sufficient cause to explain the broad rally since April, with a degree of caution appearing in September, as money went into specifically longer-duration bond funds.
That isn’t to say, of course, that neither inflation nor deflation will surface, just that these concerns don’t yet seem to be uppermost in investors’ minds.
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The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.