Fears of deflation overblown
Alan Higgins, Coutts
Investors should position portfolios for continued economic growth and modest inflation, says Coutts’ CIO Alan Higgins
We view deflation fears as overblown, with long-term inflation expectations having bottomed earlier this year and moving sharply higher since then.
Take European Central Bank (ECB) President Mario Draghi’s favourite inflation indicator - the 5 year-5 year (5y5y) forward expected rate of inflation – for example. This measure of market expectations for inflation over a five-year horizon starting in five years’ time bottomed at 1.5 per cent in January this year and is now at 1.8 per cent, close to the ECB’s 2 per cent inflation target.
Longer-term inflation expectations have shown a similar pattern in the US and UK, so fears that deflation would become embedded in market prices have clearly abated. At the same time, these expectations remain moderate - at the time of writing respective 5y5y forward inflation expectations were 2.4 per cent and 3.5 per cent for the US and UK (using the higher Retail Price Index for the UK).
We are underweight assets that would typically benefit from deflation (particularly high-quality government bonds) in favour of assets that benefit from continued economic growth and modest inflation. These would include assets that provide a growing and above-inflation income stream, such as dividend-paying equities and commercial property.
We are underweight assets that would typically benefit from deflation (particularly high-quality government bonds) in favour of assets that benefit from continued economic growth and modest inflation
While the valuation of both of those asset classes are less attractive following recent strong performance, we continue to advocate exposure to these growth assets. In particular, we expect UK commercial property to deliver superior returns to its close cousin corporate bonds, with returns being bolstered by rental growth against a background of a robust UK economy.
For income-orientated portfolios, we favour emerging-market and high yield bonds, and there may be some good risk-adjusted opportunities in ‘special situations’ debt (bonds of companies involved in restructuring, spinoffs, mergers etc) for superior income and less interest-rate sensitivity compared to ‘safer’ corporate and government bonds with higher credit-quality ratings.
Finally, we are very cautious when it comes to inflation-linked bonds, which in our view are misnamed. In reality, returns for these bonds have tended to move inversely to inflation even over medium- to long-term horizons. This reflects their high interest-rate sensitivity (duration), and the fact that a significant degree of inflation (called the breakeven rate) has already been priced into the securities.
Instead, they should be considered about 90 per cent high-duration bonds and about 10 per cent inflation protection. In summary, we favour reducing exposure to rate-sensitive assets that would benefit from deflation in favour of those that are likely to benefit from a continued modest firming in inflation expectations.
Alan Higgins, chief investment officer, Coutts
