With inflation picking up, Brian Tora looks behind the scenes at what this might mean for fixed interest investment.
Equity markets were given a somewhat surprising boost by the election of Donald J. Trump as the 45th President of the United States last November. As with the Brexit referendum, shares initially found the unexpected result troublesome, but they soon revived and markets on both sides of the Atlantic hit new high territory at around the time the new President was inaugurated in January. It seems as though the promise to provide a business-friendly environment and cut taxes reverberated.
Whether this confidence in his ability to rekindle growth and “make America great again” is justified, only time will tell. He had all the hallmarks of an “Action Man” in his early days of office, signing papers that could produce results which are difficult to foresee and in which in some cases provoked mass revolt by millions of people across the world. For our case here, perhaps it is better to look elsewhere, rather than try to second guess what the outcomes generated by this most unpredictable of leaders will produce.
The impact of inflation
And where better to look than the bond markets, which are more valuable globally than equities. Unfortunately, the outlook here looks just as obscure as elsewhere, but whoever said the business of investment was easy. Both the likely drivers of bond markets look uncertain at present – issuance and inflation. Of these, inflation is giving the strongest signal – and it is hardly an encouraging one for bond investors.
Not so very long ago, the economist Roger Bootle wrote a book entitled the death of inflation. Core to his arguments was the growth of globalisation, with emerging economies keeping a downward pressure of costs as aspirant, cheap labour ensured those countries with the ability to industrialise maintained a competitive edge. It is, after all, the basis on which China grew to become the world’s second largest economy. But some are now predicting the death of globalisation as the world’s biggest economy looks increasingly inwards.
The rise in the cost of living here at home, as measured by the Consumer Price Index (CPI), rose to 1.6% in the last published figures – which was more than had been anticipated. While this is still below the government’s target figure of 2%, there is likely to be more upward pressure on inflation as the lower pound pushes up the cost of imported goods and services. The most likely consequence of rising inflation is an abandonment of the Bank of England’s loose monetary policy and a reversal of the strategy of low interest rates which our Central Bank has employed since the financial crisis.
A global problem?
This is already in play in the US, where the pressure on inflation is even greater. CPI there topped 2% recently and the Fed is sounding increasingly hawkish. With the likelihood that the new administration will need to borrow more heavily – at least in the short term – to deliver on promises, is it any wonder that US Treasury yields have ballooned from 1.5% to 2.5% in less than half a year. Issuance could well feature in driving up bond yields, especially if trade relations with some past buyers of US government debt, like China, become strained.
Nor is inflation likely to remain a problem for the Anglo-Saxon economies. Recent CPI figures for a whole raft of countries suggest inflation is on the up. In Germany it is a tad higher than here, though the Eurozone as a whole remains muted. And actually a rise in the cost of living for the single currency region of just over 1% does look high when you think it dipped below zero not so very long ago.
Impact on bonds
So, what implications does this have for bond markets and, more importantly, bond funds? Rushing for the exit may not prove the best strategy for advisers to take at present, given that bonds will be viewed as a safe haven if the economic going gets tough. But rising inflation will inevitably force Central Banks to raise interest rates, which will have a knock-on effect in bond markets. To some extent the anticipation of such a move has already been reflected in the rise in bond yields. The question is, have they further to go? With so many imponderables, it looks like markets will be kept guessing this year.
Never say never in the investment game, but it is hard to imagine a return to those years when double digit yields were commonplace. Back in the mid 1970s, we were in hock to the International Monetary Fund, inflation had peaked at around 25% and government bond yields were heading towards 20%. Could it happen again? Unlikely, but inflation of even 3% could well impinge on bond pricing. This market has long been core to many investors seeking income. Watching the likely influences on it closely will do investors little harm.