Investment Adviser - Rocks, hard places, devils and deep blue seas.
Markets, politics and economics are all in periods of extreme volatility at present, and expressing any opinion in writing is a dangerous game, perhaps the greatest danger being that it is out of date by the time of going to press. Nonetheless as investors we must attempt to see through the chaos and make some sense of it all.
Currently the Euro crisis dominates everything and is impossible to ignore when analysing any market. Bond markets have gone through extreme moves and sit at historic low yield levels, and inflation linked markets are no exception. Indeed, the short ends of many major markets now price negative real yields. This is surely a nonsense. Or is it?
The flight from risk has been dramatic, despite some sharp moves in the other direction. Gold remains elevated despite a pullback, and government bonds perceived as safe are in strong demand. We need though to look through the crisis and attempt to see our way out. It is necessary to focus on risk premia. How much do investors expect to receive for taking a risk, such as owning a company’s share, or how much will they pay to protect themselves against these risks?
The final outcome of the Euro crisis remains unclear. Seemingly impossible outcomes clash with each other and mutually exclusive events need to co-exist. There is no legal framework for anyone to exit the euro, yet it may be necessary to create one. It would need to be done quickly, yet this requires treaty change, which of necessity is slow. All this uncertainty only adds to the justification for higher risk premia across all markets. Markets hate uncertainty above all things, and will charge for it.
The broader financial chaos of the last few years has demonstrated very clearly a change n the reaction functions of governments and central banks. They are far more likely now to over-stimulate rather than under-stimulate economies. The Bank of England’s re-starting of QE despite elevated inflation and positive growth is a prime example. If they’re going to make a mistake, they’re pretty clear it will be on the up side.
This means we need to examine the risk premium for inflation. If we accept that central banks have any control on inflation at all (which could easily be the subject of another article), then we must accept that the distribution of outcomes for inflation is now asymmetric. Inflation protection has in fact become cheaper through the crisis, as implied inflation expectations have fallen. We measure this, broadly, by looking at the difference between nominal and inflation linked bonds of similar maturities, and this gap has been falling as the markets focus on weak economic prospects rather than any likely future outcome for inflation. This is natural, but ignores the fact that part of that spread is not inflation expectations but a risk premium
Unfortunately that premium is nigh on impossible to isolate, despite many academics trying for a long period, so we have to look for proxies. One of those is the slope of the inflation swap curve. A common measure is the spread between the ten year forward starting ten year inflation swap and the five year forward starting five year swap. This convolute language asks, in simple terms, how much extra we are paying for longer term inflation insurance than shorter term.
For the UK, which has had a persistent, niggling inflation problem in recent years (which has seen the Bank of England stretch the definition of “transitory” to near breaking point), this measure of the inflation risk premium has risen above where it was before the financial crisis, This seems logical given recent inflation history. For the US however, where, we need to remember, the government still has its foot on the fiscal accelerator as well as monetary policy still being at full stimulus pelt, that premium is virtually zero. This would seem to be far too cheap given the current risky circumstances.
For Europe, the premium, by this measure, is also near zero. Given the doom laden economic forecasts for the Eurozone this is less surprising, but there should surely be a risk that any solution for the crisis could result in excessive stimulus, leading to inflation of some sort.
These cheap premia suggest that a portfolio of global inflation linked bonds remains attractive, certainly compared to a UK only inflation portfolio. It also suggests that inflation linked bonds offer value relative to nominal government bonds. If yields rise as economies recover, it is likely that inflation linked bonds will out-perform nominals very sharply. A global portfolio is also shorter in duration than a UK one, which would be further down side protection as well as inflation protection. If on the other hand, yields fall, we should expect real yields to fall as well, as economic prospects become even more dire. There is therefore a very attractive risk reward relationship for inflation linked bonds over nominals.
In times such as these where policy makers are required to square circles and solve intractable problems, the one clear message is that the risks are high. Investors should seek assets where risk is not expensive to insure against, and inflation linked bonds appears to be one of them.
Jonathan Gibbs, Head of Real Returns, Standard Life Investments
First Published in Investment Adviser on 12th December 2011