Institutional Money (8.11.2021) - Coming into the final quarter of the year, our view had been that the economic recovery would allow central banks to start guiding towards less accommodative policies, and that this would provide room for rates to rise.
This was particularly apparent at the front end of the US rate curve, with the Fed’s market pricing being well behind its own dot plot projections. This defensive view on duration remains intact and has been backed up by the growing inflation theme. Although we ultimately anticipate that inflation will be contained in the medium term, the shifts in consumer behaviour that we have seen since the pandemic began are unlikely to revert back overnight and this could keep bottlenecks in place in the short term.
We continue to view the macro backdrop as a positive environment for credit markets, as, although central banks are reducing their stimulus measures, we still expect their actions to be gradual and we therefore do not anticipate an aggressive tightening in financial conditions as a result. This should allow investors to instead focus on credit fundamentals, which have been improving in light of strong earnings and prudent balance sheet management. We would also emphasise that modest inflationary pressures can actually be good for corporates, as our analysis indicates that over 80% of the EUR IG market should see a neutral-to-positive impact from inflation. One of the largest beneficiaries of this higher-rate environment will be financials and we continue to see subordinated financial debt, in particular AT1s and high-yield, as being attractive given current valuations and solid fundamentals.
Looking at the latest inflation dynamics in more detail, we view the recent upward move in prices as a consequence of the change in behaviour due to the pandemic, which has led to shifts in consumption and created bottlenecks. For example, since the pandemic began, demand for products from Asia has increased, resulting in a global export imbalance and surging freight costs. This behavioural shift is still in play, given that mobility is lower than before the pandemic despite reduced Covid fears, and this also appears to be a reason why the labour market is yet to fully recover, despite continued demand for workers.
As we look ahead, we therefore see consumer behaviour as a key input in determining how long above-target inflation will last. If, for instance, consumer behaviour reverts back to how it was before to the pandemic in the coming months now that Covid cases appear to be under control with the vaccine rollout having progressed globally, then, in this scenario, we would also expect inflation to return towards more normal levels in the coming months. This is clearly the view shared by the Fed and the ECB based on their latest forecasts. If, however, these shifts in behaviour and demand are more permanent, then the capacity will need to be built to deal with them. If, for example, we look at semiconductors, estimates suggest that it would take around two years for the necessary capacity to be built up to match the demand needs. Once built, this should also then alleviate price pressures and eventually allow inflation to remain contained in the medium term.
We also think it is important to stress that modest inflationary pressures can actually be seen in a positive light. As mentioned above, only a small portion of the EUR IG credit market will see a negative impact from inflation. The sectors that will suffer are those most vulnerable to higher raw material, energy and labour costs. However, in contrast, we expect bank profitability to benefit from higher interest rates, and oil & gas producers to capitalise on higher energy prices. For sovereigns, inflation is coming at a time when budget deficits have widened due to the social support provided during the pandemic and therefore inflation could help cushion these deficits.
Turning to central banks, we see higher inflation as actually providing them with the opportunity to finally lift rates off the zero lower bound. This is crucial, as it will provide them with ammunition down the line to cut rates once again when the next recession hits, providing another monetary support tool beyond just the balance sheet. Although inflation risks have risen, crucially, the reaction function of policymakers to inflation has also changed; for example, the Fed’s average inflation targeting framework provides them with the flexibility to not tighten policy aggressively, despite core PCE being above target. This is in stark contrast to what we have seen during previous inflationary episodes and should be seen as a source of comfort for markets.
In summary, whilst inflation fears have clearly risen of late, we anticipate that prices will be contained in the medium term and modest inflationary pressures in the interim could actually be positive for credit markets. We therefore remain positive on credit, having a preference for the high-beta segment, such as subordinated financial debt and high yield, whilst seeing room for rates to rise, particularly at the front end of curves, as central banks have passed peak stimulus.
Philippe Graüb
Head of Global Fixed Income
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