Bonds Yield to Inflationary Pressures
Outside of watching events unfold in Ukraine and the ‘West’s’ response, the major development for financial markets has been the continued rout in bond markets.
Shortages of key materials, exacerbated by the Ukraine conflict, plus shipping delays from Covid-related lockdowns at major Chinese ports, have underpinned the ‘higher inflation for longer’ argument.
Faced with higher-than-expected inflation data in the first half of April, the US Federal Reserve has made its feelings quite clear – that it is serious about curbing inflation by bringing a more abrupt end to quantitative easing (QE) and emphasising its determination to increase official short term interest rates over the balance of 2022.
A need to re-establish credibility perhaps.
The Bank of England, while not as vocal, is of a similar mind. The following chart from Investing.com illustrates both the volatility of UK ten-year gilt yields in recent weeks and the sharp rise in yields.
The Office for National Statistics (ONS) reported on the UK’s consumer price inflation (CPI) on April 13th.
The problem for the UK is that it’s economy has slowed considerably, growing by just 0.1% in February 2022. While inflation is this year’s problem and may become more entrenched due to economies wanting to be less dependent on supplies from far afield and from less friendly countries, there are concerns that recession or perhaps stagflation could manifest next year.
Tight labour markets continue, and with them, upward pressure on wages. Last week, the ONS reported that in the three months to end February 2022, UK unemployment fell to 3.8%.
There is a lot of rate hiking priced into markets as the following chart from JP Morgan Asset Management illustrates.
It is possible to paint a backdrop where bonds have the potential to do better if US and UK economic growth hits a wall and central banks do not follow through on the predicted rate increases shown above.
The problem for bonds, both government and credit, is that after a number of years of artificially maintained low nominal yields by central banks, the transition to ‘normal’ leaves yields still below the point where they represent an attractive investment in multi-asset portfolios.
The shape of yield curves and their flirtations with inversion (long rates below short rates), gives some clues as to market expectations over the longer-term inflation picture. For us, the demand/supply outlook favours commodities over bonds.
For those looking for a shaft of light from the recent inflation data, the following chart sourced from The Daily Shot shows US core CPI detaching from the headline number and trending down.
There was a reduction in small cap exposure in UK equities in favour of a new position in a global infrastructure fund which is also a good diversifier within the funds’ equity allocations. Cash positions have been maintained at close to 10% as a defensive stance and commodity exposure has also been maintained. In the multi-asset funds, commodities have proved to be a better balancing asset class than bonds.
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