by Dewi John.
Inflation has become a hot topic. Friedrich von Hayek likened controlling it to catching a tiger by the tail. Are UK investors making a grab for this least friendly of cats?
As Bank of England chief economist Andy Haldane tells it, “for many years, the inflationary tiger slept,” though now the “combined effects of unprecedentedly large shocks, and unprecedentedly high degrees of policy support, have stirred it from its slumber”.* Like any good economist, however, he hedges his bets, as “it would be spuriously precise” to assign probabilities to either inflationary or deflationary outcomes. That doesn’t stop the Monetary Policy Committee, on which Haldane sits, estimating a one-in-three chance of inflation lying below zero, or above 4%, at its two-year policy horizon. Perhaps this is the committee’s idea of ‘validly imprecise’.
Since the fourth quarter of 2020, the inflationary drums are beating loader. Broadly, a recovery from COVID is expected to unleash pent-up demand, as we all rush out on holiday, get our hair cut and gorge on restaurant fayre. Asset prices have bounced back, the most dramatic example being that of oil, where WTI Crude went from almost -$37 a barrel in April 2020 to above $60 and climbing.
Then there is the vast government spending to support the economy. The US has spent 30% of US GDP on COVID support, compared to 5% in the aftermath of the global financial crisis. And, of course, there’s more to come, with the US rolling out a $1.92trn recovery plan.
However, this side of the pond, there’s not much sign of inflation yet, as you can see from chart 1. It’s ticking up, but from a very low base.
Chart 1: UK CPI Inflation, February 2016 to February 2021
Source: Refinitiv Eikon
Finance professor Jeremy Siegel, writing in the Financial Times, warned “higher inflation is coming, and it will hit bondholders”. Inflation reduces the real value of fixed income streams, so is bad for bond investors. “It will be the Treasury bondholder, through rising inflation, who will be paying for the unprecedented fiscal and monetary stimulus over the past year,” said Siegel.
Investors can respond to this through a combination of cutting bond exposure, shortening duration, and switching from conventional to inflation-linked bonds. The broad rally following last April’s collapse was followed by a degree of caution in September as money went into longer-duration bond funds. For much of 2021, governments and central banks were firefighting the pandemic, so that’s no surprise: back in September, few were fretting about inflation, bounce or no bounce. Then, the end was far from nigh, pandemic-wise, and Joe Biden was still nowhere near the White House. Things have changed—but have investor expectations?
That certainly seems to be the case in the US. Refinitiv Lipper research for the US market showed net flows into Inflation Protected Bond Funds for both January (+$5.9bn) and February (+$3.6bn). These were record amounts going back 2002, when this classification was created.
Chart 2: Bond Fund Flows, February 2010 to February 2021
Source: Refinitiv Lipper, three-monthly period to end-February 2021
The UK seems rather more sanguine about the prospects of domestic inflation. There’s no sign that investors are bailing out of bonds. UK fixed income flows for the quarter to the end of February 2021 were £5.1bn (Chart 2). The 10-year quarterly average is £3.2bn, so flows are significantly up. This isn’t the bond bloodbath that many have been expecting. Or, if it is, no-one has seen fit to tell fund buyers.
How does this pan out when we look at more granular bond classifications? If investors are hunkering down for a significant uptick in inflation, you would expect to see flows towards inflation-linked bond funds, which would give a measure of inflation protection. And, as illustrated above, that is indeed what US investors are doing.
Chart 3: Bond GBP Inflation Linked versus Bond USD Inflation Linked Flows, December 2017 to February 2021 (£bn)
Source: Refinitiv Lipper, three-monthly period to end-February 2021
Chart 3 tells an interesting story. Over four years, flows into Bond GBP Inflation Linked funds peak in the three months ending May 2017, at £1.37bn. This is at a time when inflation is climbing relatively steeply, to top out in the autumn of 2017 at 2.8% (see chart 1). As UK CPI declines thereafter, flows mute and eventually go negative. Over this period, you have to squint to see US linker flows. They become meaningfully positive as UK inflation continues to trend down, while US inflation stays around the 2% mark. It’s also at a point, from late 2018, when President Trump gets into a public row with the Federal Reserve about raising rates.
So far, so much ancient history. But it does show us that UK investors were behaving rationally, in moving their money out of UK linkers while buying US ones as US and UK base and inflation rates diverged.
What’s happening now? Since the summer, both US and UK linker flows have turned positive, indicating that UK investors expect inflation. But they’re expecting it much more—if these figures tell us anything—from the US (£1.77bn versus £700m for GBP-denominated inflation-linked bonds). The current trend is unusual, as there has been only one three-month period over the past decade that USD flows exceeded GBP flows when both were positive. Bond USD Inflation Linked flows are normally a fraction of their GBP counterparts (remember, we’re just talking about UK investors here).
The inference, then, is that UK investors agree with their US counterparts, and expect to see US inflation. They expect it less—or later—in the UK.
What is not clear is whether investors are making a bet that the UK has less to fear from inflation—making GBP bonds a better bet—or whether inflation is just going to feed through at a slower rate. Either way, it could support continuing flows to GBP bonds over the coming months.
* The unprecedented shock of COVID has led to the unprecedented use of ‘unprecedented’ by an unprecedented number of commentators.
This article appears as Investors are gearing up for US inflation in FTAdviser
Refinitiv Lipper delivers data on more than 330,000 collective investments in 113 countries. Find out more.
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.