Inflation has surged in the US on the back of a strong economic recovery, huge stimulus programmes, and loose monetary policy. What are the implications for fixed-income investors?
Even as the United States (US) economic recovery appears on track, with first-quarter GDP data printing annualised growth of 6.4%1, inflation is making a comeback. Data for April 2021 showed that price rises had soared to a 13-year high, with the Consumer Price Index (CPI) registering a 4.2% annual increase – compared with just 2.6% the month before2.
This number was far ahead of expectations and has led to a major question: is this inflationary surge temporary – a supply-driven response to economic reopening – or permanent and structural, with long-term demand-pull factors in the equation as well?
The US Federal Reserve (the Fed) believes this inflation is “transitory”3 and is committed to maintaining its monetary policy and bond-purchase programme. However, not everyone sees eye-to-eye with the Fed. Warren Buffett noted at Berkshire’s shareholder meeting that he observes “very substantial inflation”4. Even Treasury Secretary Janet Yellen has conceded that interest rates may have to rise to prevent the economy from overheating5.
More data and time will be needed before we can settle this debate. Still, investors have already reacted. In the equity markets, reactions have been mixed. While the S&P 500 briefly dipped on the news, it has since recovered6. Asian stocks, though, have pulled back.
On the fixed-income side, US Treasury yields fluctuated but remained stable7, while yields in other developed markets have generally increased. All said, the spectre of inflation is placing many investors – especially those focused on the developed space – between a rock and a hard place.
Here is the dilemma facing fixed income investors in developed markets. Although government bond yields have risen in the past few months to pre-pandemic levels, these remain at historic lows. It is worth remembering that the “hunt for yield in a low-yield world” theme existed for years before the pandemic – and still persists.
Meanwhile, inflation expectations – as measured by the breakeven inflation rate – are at their highest in eight years8. Add the ongoing economic recovery and stimulus programme to the mix and we see significant upward pressure on yields, meaning investors are also faced with the prospect of further capital losses.
In other words, these investors must confront a landscape of low yields coupled with the likelihood of falling bond prices. Faced with these options, it’s not surprising that many have turned to Asia’s bond markets, which are better placed to thrive amid a strong US economic recovery and an inflationary surge – whether transitory or structural.
Since the unexpected inflation data is very recent, we can assume a transitory scenario for the moment. So far, Asia’s bond markets appears to have reacted positively to the data. Yields on the Markit iBoxx ABF Pan-Asia Index, which tracks local-currency government and quasi-government bonds in eight Asian markets, have declined by six basis points from end-April to 26 May 2021 – meaning their prices have increased9.
If price rises dissipate over the coming months, it implies that US domestic demand is not strong enough to stoke structural inflation. As long as growth remains reasonably healthy, the overall investment risk appetite would still be robust.
This scenario would support the broader class of Asian assets, as they generally benefit from a higher risk appetite. However, if transitory inflation is paired with slowing growth, this might dampen any desire to assume more risk – pushing investors toward defensive markets with more robust fundamentals. While this would necessitate careful credit selection, stronger Asian asset classes could still benefit, such as Chinese government bonds.
A scenario where inflation is more permanent implies supply factors – such as wage increases – coupled with higher consumption demand. While this might result in a sooner-than-expected Fed tightening, it would also suggest positive economic prospects for the world’s largest economy. This would likely also lift the global growth outlook, which would benefit export-driven and commodity-producing Asian markets.
Of course, there are caveats. A key reason behind America’s economic recovery is an admirable vaccination programme, with over 285 million doses administered by May 24, 202110. Except for China11
and Singapore12, few Asian territories have vaccinated a significant percentage of their population – leaving them vulnerable to future Covid-19 outbreaks. Indeed, we already see new surges across the region.
That said, the impact of such surges may be primarily constrained to specific industry sectors and thus mostly affect the corporate bond market. As long as the overall economic picture is not overly impacted, lower-risk government bonds are likely to present an attractive risk-reward proposition.
It remains to be seen how the US inflationary story will play out in the longer term. Regardless of the situation, there is a good likelihood that Asian bonds will remain an attractive play. The yield pickup is good, its currencies are resilient13, and default risks can be managed by focusing on government bonds.
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9. Source: State Street Global Advisors
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