Former Reserve Bank of Australia governor Glenn Stevens thinks global investors are complacent on the risks of a sharp rise in inflation
Inflation linked bonds have been popular investments with FIIG clients for many years. At any one time, roughly 90% of our investors would own one or both of the Sydney Airport 2020 and 2030 capital indexed bonds. We’ve highlighted the risks and suggested a weighting to inflation for as long as I can remember.
While inflation has been relatively low and stable, some clients have chosen to take profits and reduce weightings to inflation linked bonds.
Yet, Glenn Steven’s comments last week may have you reconsidering your allocation. Below is an excerpt from his paper ‘Are we there yet’, published this month and available on the Ellerston Capital website.
“The fact that the expansion has been moderate in pace thus far also means that inflation has, to date, remained quite low, unusually so for an upswing that, in calendar time, is now getting on. (The US upswing, for example, is now 100 months old or more, one of the longest since business cycle records have been kept.)
That has meant that monetary policies everywhere have remained remarkably accommodative which, in turn, has ruled out, so far, the expansion ending because of abrupt policy tightening to counter inflation in the fashion seen from the 1960s to the late 1990s.
Of course it’s not just inflation that can help to precipitate the end of an upswing. Over the past couple of decades, the usual story has more often one of financial problems: some sort of ‘imbalance’ or ‘vulnerability’ that arose in an economy during the expansion and which put the economy at heightened risk of a reversal. A build up in debt, associated with rising asset values, took place. Then at some point an event caused people to re-evaluate the likely returns on assets, and hence their prices, and what degree of borrowing seemed sustainable. Sometimes, such re-evaluations turned out not to be that big a deal for the real economy. A case in point was the dot-com bust of the early 2000s. That reversal was associated with a recession in the US, but quite a mild one compared with those that had been associated with the fight against inflation. It seems that the relatively moderate extent of leverage behind the asset holdings at the time was a key ameliorating factor.
On other occasions, the asset price-debt-credit quality nexus started a contractionary process that was devastating – as in the great financial crisis in 2007-2008…..
One problem in assessing this issue is that no one can be sure what ratio of debt to GDP or income is too high, because what is sustainable depends on interest rates, among other things. Since interest rates have been remarkable low for the past decade – some suggest the lowest in recorded human history in nominal terms – debt servicing has been fairly easy. Indeed, that is part of how expansionary monetary policy works. Of course there is the question of how borrowers will fare once rates rise – an important consideration and one which, all other things equal, will surely see central banks proceed very carefully in their tightening programs over the years ahead”.
Third quarter inflation figures are due out on Wednesday. Expectations are for a 0.8% headline quarterly figure, which will bring up the annual figure to 2.0% - just making it back into the 2-3% band. Still plenty of room for upside therefore, if the former RBA governor is to be believed.
FIIG investors
I would expect most FIIG investors to have acknowledged the risk of higher inflation and have some weighting to inflation linked bonds in their portfolios. If you are looking to top up, we show yields over CPI for a range of capital indexed bonds and indexed annuity bonds below.
Capital indexed bonds
Source: FIIG Securities
Spreads accurate as at 23 October 2017 but subject to change
Index annuity bonds
Source: FIIG Securities
Spreads accurate as at 23 October 2017 but subject to change
Not sure if you have enough of a hedge?
Our Portfolio Strategy Service team recommend clients allocate between 20 and 40% of their portfolios to inflation linked bonds.
Last week, Craig Swanger began a three part series, assessing the prospects for inflation. Click on the link to access Part 1, “The bull market in everything: Will inflation finally kill the bull?”. Part 2 will be published next week.
For more information, please call your local dealer.