Inflation-linked bonds are a valuable diversifier

The fading reflation trade and the disappointing wage data that we have seen of late have hampered investor enthusiasm towards inflation-linked bonds. After a strong performance in late 2016 and in the earlier part of 2017, the asset class has come under some pressure lately, reflecting expectations of lower inflation ahead.

While we do agree that the outlook for global inflation is less clear cut today than it was a year ago, given lack of wage growth and tighter monetary policy in developed markets, we find that the recent underperformance has created value in some areas of the asset class. With several inflationary risks still on the horizon, the asset class can still work as a valuable diversifier to nominal duration.

This is particularly the case in US inflation-linked bonds, where we have seen a sharp repricing of the “Trump trade” as the challenges of getting reforms passed in Congress became apparent. 10-year US breakevens have tightened from over 2% in January to 1.77% currently, with the latest batch of soft inflation and wage numbers adding additional headwinds. Looking ahead, we expect headline US CPI to remain low and trough at around 1.5% next year. Compared to our forecast, breakeven valuations are appealing at current levels. Investors no longer expect any meaningful reform to be approved in the US, and any step forward by Congress on taxes or investments would be a positive surprise. By the same token, protectionist policies that could cause a one-off spike in US inflation could easily come back on the agenda. Lastly, the recent bout of USD weakness may translate into higher goods prices in 2018, supporting inflation expectations and US breakevens,

In Europe, we forecast inflation, as measured by the Harmonised Index of Consumer Prices (HICP), to remain subdued this year, despite some potential upside in food prices. Over the course of 2018, we expect Eurozone inflation to remain in a 1-1.5% range, still far from the ECB target of close to 2%. The lack of upward pressure in wages and the recent appreciation of the EUR will provide further headwinds to Eurozone inflation and will no doubt be a challenge for the ECB. The Governing Council appears on course to announce further tapering of the QE programme from January 2018, but they are likely to follow a very cautious and flexible approach to allow for any negative surprises on the growth front. While the outlook for Eurozone inflation appears benign, the market is already pricing this in and valuations warrant an overweight stance given the asymmetric risk-reward.

Andrea Iannelli, Investment Director, Fixed Income, Fidelity International

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