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Reflation looms? Are you ready?



17 March, 2021



Inflation markets year to date

The first quarter of 2021 brought inflation – or at least the fear of it – back into focus. Continuing the trend that started in November 2020 following good news on COVID-19 vaccines, inflation expectations (measured by breakeven inflation1) and longer-maturity core government bond yields have been rising considerably across the globe. This reminds investors of the wider range of possible inflation outcomes and the potential impact on their portfolios, as we examined in last year’s “Beware of the Inflation” paper.2


Since the beginning of the year, breakeven inflation rates have been increasing for the US, UK, Australia and continental Europe. Year to date (to March 16, 2021) 10-year US, UK and Australian breakevens have increased by 32, 47 and 38 basis points respectively and breakevens for major Eurozone economies (Germany and Italy) have increased by 36 and 39 basis points, respectively.3


February 2021 was particularly interesting for US breakeven inflation. While the 10-year breakeven rate was mostly flat, the 5-year soared by 20bps, rising to a 10-year high. In other words, although markets are pricing US inflation over longer periods (10 years) at slightly below the FOMC’s target,for the medium term (5 years), implied inflation is edging closer to the target – closer than it has been since prior to the Global Financial Crisis. For other countries, we have seen similar moves in February but less pronounced than for the US.5 What are markets trying to tell us?


A year like no other… followed by a year like no other

Last year when economies around the globe shut down overnight, we entered a disinflationary and, in some cases, outright deflationary environment, because people stuck at home consumed less. Goods consumption picked up after the initial shock, but service consumption continued to lag behind. Actual inflation only recovered gradually over the summer and slowed again with restrictions returning in fall.


This year, markets are expecting quite a different trajectory.


For over a year, most of us have been unable to pursue leisure activities because of pandemic-related restrictions. At the same time and unlike in past recessions, the fall in household incomes in many countries was actually mitigated via income support programs that allowed affected (and also unaffected) households to get by and, in the case of the US, to actually pay down debt and build up savings.

The combination of financial firepower ready to be deployed by households and the craving to again enjoy socializing, travelling and in-person entertainment is expected to unleash a wave of pent-up demand we have not seen since the end of WWII. Service providers will be more than keen to accommodate, but getting supply back overnight will be challenging, at least in the short term. Short-term demand outpacing supply could therefore be reflected in prices in certain sectors and, thus, higher inflation for 2021 at least.


On the other hand, the large output gap (i.e., potential GDP growth less actual growth) is still significant in some regions, such as the Eurozone, so unemployment numbers are expected to act as a dampener on the transitory jump in prices.


The pace of the recovery will differ by country, as it depends on the vaccine roll-out and the associated ability to fully reopen. This is what markets have been pricing in last month – a sharp increase in medium-term (5-year) inflation expectations in the US and UK and no increase in the Eurozone as the slow roll-out of the vaccine by the EU will defer a full reopening driven rebound for now.


For the US, the pending stimulus is an additional elephant in the room. It was no coincidence that the rally in 5-year US inflation expectations coincided with the third US fiscal stimulus package of $1.9 trillion (around 9% of GDP) clearing its final hurdles. Many fear that such a large package will only add fuel to the fire as it will coincide with a massive recovery. In the UK, the budget released in early March includes another stimulus package of $90 billion (around 3% of GDP). Although the EU stimulus of $2.2 trillion (around 12% of GDP) is also sizable, it will only be disbursed gradually, starting this year, with more targeted measures than blank cheques to consumers. Inflation markets at the shorter end of the curve have therefore reacted most sharply to the latest US stimulus package.


Finally, on the monetary side, an economic recovery and expected inflationary pressure would normally lead to a tightening in monetary policy. However, this recovery is different, with central banks erring on the side of caution, potentially allowing inflation to overshoot targets rather than nip any recovery in the bud. Indeed, the whole idea of inflation targets has begun to morph, with the Federal Reserve joining Australia’s RBA in utilizing an average inflation-targeting framework.6 The European Central Bank is also considering an average inflation target as it reviews its monetary policy framework this year.


Where we go from here will ultimately depend on actual inflation and how central banks respond. If inflation overshoots and the Federal Reserve starts tightening, inflation expectations could fall back down again and stabilize. However, if inflation is allowed to run hot and markets believe this is the new normal, we could see inflation expectations rebase higher again and stay there.


Inflation outlook

We have been recommending since last year that investors should prepare for a wider range of inflation outcomes for the decade to come, including the risk of inflation surprises.


For 2021, we expect a material pick-up in inflation, partly because of the base effects (when we compare prices this spring to last spring when economic activity was paralyzed, there will naturally be a jump7), but also because of pent-up demand, the size of which being subject to the reopening schedule of each country. Thereafter, we expect some stabilization from 2022 onwards.


Beyond then, we might see a situation where central banks are more accepting of higher inflation and less independent from government. In addition, the aftermath of the government borrowing spree may lead politicians to be tempted to reduce the deficit in real terms by pressuring central bankers into running higher inflation. Finally, given increased political polarization, the risk of increased trade barriers, de-globalization and redistributive populism as structural inflation drivers remains.


Portfolio implications


Dynamic Asset Allocation

We started 2020 with a tactical overweight on global inflation-linked bonds relative to nominal bonds in our strategic reference model portfolio. Nevertheless, we decided to maintain the position at a moderate overweight, even when inflation expectations collapsed during the COVID-19 shocks as we anticipated this shock to be temporary – a view that was strengthened with the vaccine announcement in November 2020 and subsequent roll-out.


Strategic Asset Allocation

Although our long-term (>5 year) base case of moderate inflation around central bank targets for most regions has not changed, the range of outcomes has become wider. This is a direct consequence of the events of 2020 in the form of higher inflation tolerance by central banks and increased monetary/fiscal coordination. At the same time, structural factors that were already at play before 2020 have been accelerated by the pandemic. This includes the aforementioned slowing pace of globalization and redistributive populist pressure that could lead to labor reasserting itself. We believe long-term inflation risks have shifted to the upside, and the risk of inflation materially overshooting official targets during this decade is now higher than it was before the pandemic.


We believe a review of an inflation-sensitive sleeve is prudent to ensure that portfolios can withstand sustained higher inflation, as well as inflation surprises, over the next decade. Last year, in addition to the allocation to real assets in our strategic reference model portfolios, we introduced an inflation-sensitive sleeve currently consisting of inflation-linked bonds. We are actively monitoring the merits of gold and other assets for future inclusion in this sleeve. Different inflation-sensitive assets work better at different points of the inflation cycle and respond to inflation expectations and actual price inflation differently. Building a robust inflation-sensitive sleeve as part of a broader portfolio is a prudent step to face the policy uncertainty of the next decade.


Christian von Canstein
Christian von Canstein
MSc, CFA, CAIA Investment Research Specialist

[1] Inflation expectations implied by the market. Breakeven Inflation is calculated by taking the difference in the yield for nominal and inflation-linked bonds of equivalent maturity. As nominal bonds compensate for an expected level of inflation and inflation-linked yields pay the investor the actual realized inflation, the difference between the two reflects the inflation expected by market participants of the stated maturity.



[4]The level of inflation targeted by the Federal Reserve is 2% as measured by the Personal Consumption Expenditure index that translates to around 2.5% using the Consumer Price Index used for TIPS. As breakevens are based on CPI, the 2.30% rate as at March 16, 2021 priced by the market over 10 years is roughly the equivalent of 1.80% PCE.

[5]UK, Australian and German 5-year breakeven rose 20 bps, 16bps and were flat respectively.

[6]The Bank of Japan does not have a formal average inflation-targeting framework in place but is also committed to overshoot its inflation target of 2%.

[7]The UK and Eurozone have adjusted the inflation baskets to consider changes in spending patterns over the last year, which might mitigate the base effect to some extent in these regions.

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    March 2021