HSBC’s Willem Sels asks: Should markets fear rising inflation?

Willem Sels, UK head of Investment Strategy at HSBC Private Bank, queries whether inflation really is as great a danger as some expect.

Higher oil and food prices could halt the current trend of falling inflation, but they should not cause a sharp inflation spike for now. Quantitative easing however is raising long term inflation expectations.

As a result, inflation-linked bonds should outperform fixed rate conventional bonds. Given the importance of food prices for EM, volatility could rise in the region, but the effect should vary by country and be limited for commodity exporters. Globally, we do not think that inflation will accelerate enough to endanger the current improvement of equity markets.

Safe haven government bonds have become more volatile in recent weeks, with US Treasury 10year yields moving from 1.38% to 1.83% in less than three weeks (before falling back somewhat). The resulting 4% price correction causes some investors – rightly in our view – to question the ‘safe haven’ label of sovereign bonds. If one expects a 1.4% income return, a 4% price move is hard to stomach. Our global investment committee recently further downgraded sovereign fixed rate bonds to a full underweight.

Increased bond volatility: what are the drivers?

The drivers of rising yields and higher volatility are manifold, but can be grouped into four themes: 1) the effect of commodity prices on current inflation, 2) the effect of quantitative easing on long term inflation expectations, 3) signs of improved risk appetite, and 4) positioning and valuations. We will discuss each of those in turn and attempt to forecast if they have further to run.

1. Commodity prices

Agriculture prices have risen significantly, largely as a result of bad weather. The drought in the US has been decisive for global market prices; the US is now expected to export 14% less corn and 15% less soy in 2012 than in the past four years. But there have also been droughts in South Korea and North-East Brazil, as well as flooding in India, Russia, the UK and North Brazil. However, the trend hasn’t been confined to agriculture, as oil prices have spiked as well, largely as a consequence of production disruptions in the North Sea and concerns over tensions in the Middle-East.

We are reluctant to extrapolate the recent moves, though. Most of the drivers of higher prices have been due to supply disruptions, while demand remains subdued due to slow global growth. We think this should cap further upside for commodity prices.

Still, even if commodity prices remain unchanged from here, we believe that they will put some upward pressure on inflation (or at least halt its current downward trend). This is because rising commodity prices tend to push up inflation with a lag of 4 or 5 months.

The effect of food and oil prices on inflation varies by country. Emerging markets tend to be more sensitive to higher commodity prices than developed markets, but this is not uniform. Some countries limit the impact by subsidising prices, which caps inflation pressures. The impact on the local economy, stock prices, currencies and credit spreads, of course, also depends on whether the country is an importer or exporter of commodities.

If commodities were to move higher still, we would likely increasingly move towards commodity exporters, but we are not making a broad shift at this stage because we think slow global growth will cap upside for commodities. Nevertheless, we maintain some exposure to EM inflation linked bonds.

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