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INVESTING/PORTFOLIO STRATEGIES

Inflation innovations: Return ideas for fixed-income investors

Despite a year of shock results and surprises, the U.S. economy is displaying positive momentum. Survey and sentiment data remain strong, aided by expected growth in the energy and manufacturing sectors, despite a few bumps in the road from hard numbers, such as auto sales and construction figures. Whether President Donald Trump's infrastructure plans come into effect this year, animal spirits have been rekindled by his rally calls. But there is one factor returning to view to provide a challenge for the whole of the nation: Inflation is on the up.

Data are showing a gradual increase in prices, particularly in the U.S., where year-on-year inflation increased steadily through 2016 and into 2017. It is now approaching the Federal Reserve Board's desired 2% level. Looking past the volatile food and energy components, service sector inflation has been creeping upward for more than 12 months. This is most evident in the medical sector, where care services cannot be outsourced abroad. In the labor markets, the industries so hard hit by the tumble in oil prices have started to rehire, with this increased demand for workers across retail, construction and the oil industry itself adding to inflationary pressures. On some measures the U.S. labor market is as tight as it was in 2006.

In Europe, inflation is coming off a very low base, but higher economic activity is pushing levels up nevertheless. The U.K. is vulnerable on the back of currency weakness, although the domestic economy has proven surprisingly resilient since the Brexit referendum.

Despite the global trend, our view is that these indications do not suggest we are facing a shock environment of persistently elevated inflation, but rather, a more nuanced state of gradually increasing levels. Central banks are clearly following the trend closely and moving into position to act decisively on rising inflation via rate hikes — looking to normalize the rates environment sooner than later. We anticipate seeing two to three hikes by the Fed in 2017 in an attempt to catch policy up with shifting economics. For already pressed fixed-income markets, these increases should come as further blows, pushing up yields and leading to losses in many portfolios that rely on traditional Treasury allocations. Investors need to act now.

What to do

First and foremost investors must reduce their duration as much as possible to minimize losses as yields rise; but then how do you generate returns? Inflation-linked bonds are an obvious answer, but break-even rates have risen significantly since the summer of 2016 and look far from attractive. This is where creative thinking and esoteric active management come into play — we believe unconventional assets are likely to be the trades that should deliver in this changing environment, while the tried-and-tested classics clock up negative returns.

Here are our five inflation-fighting approaches for creative fixed-income investors.

  • Play the yield curve: Prepare for steepening developed market yield curves using forward-starting interest rate swaps, such as five-year swaps starting in five years' time. It isn't possible for many investors to physically short the bond market, but we expect prices to fall, so derivatives such as swaps provide a strategic way of capturing gains even in falling markets. Forward-starting swaps offer notable value as, due to their more complex nature, there are fewer participants using the instruments, less analyst coverage and more unexploited opportunities available. We currently favor shorts in Europe and the U.K. against cross-market longs in Sweden and New Zealand.

  • Currencies: Tactical currency positioning is a very useful strategy when buy-and-hold is no longer a lucrative option, especially for U.S. investors, as the dollar will likely appreciate further over the long term. Sentiment is a crucial indicator when placing these positions, as markets can rapidly shift, with trades needing attentive active management to keep positions in tune with market positioning. The Mexican peso is currently cheap on numerous measures, as it prices in a worst-case U.S. trade policy scenario.

  • Emerging markets: With the majority of economic fundamentals for emerging markets at their strongest level in five years, activity is quickly picking up in the emerging markets region. Growth rates are beating those of developed markets, causing the growth differential to widen. Relative EM asset prices are well correlated to this differential, so continued EM growth might lead to local currency debt outperformance. Politics is the one major threat to this trade. But with the fundamentals so good, growth is already beginning to surge and the balance of payments looks rock solid.

  • Convertible bonds: Convertibles offer the unique ability among fixed-income assets of allowing investors to exploit upside in the equity markets. After delivering good performance in 2016, the asset class is off to a strong start in 2017. We expect this to continue, providing the equity backdrop remains favorable, as it is now. A bottom-up approach laced with manager skill is the key to a successful allocation.

  • Trade finance: While U.S. rates will certainly rise, trade finance remains an attractive alternative to what remains a low bond and sometimes negative cash yield environment. Investment-grade insured trade payables offer a more attractive return than cash and near-cash investments, with yields of around 100 basis points in U.S. dollars and a positive number in euros.

Conclusion

Steadily positioning long traditional bonds is no longer an option for most, as geopolitical turbulence combined with inflation upticks are changing the field of play. But while the hunt for yield has become more challenging, we believe the asset class should continue to offer attractive returns for those who know where to look and who are prepared to stray off the beaten path. Tweaking your fixed-income allocation could make the difference between dragging behind in another tough season or capitalizing on change and cleverly capturing value.

Tim Haywood is investment director at GAM for absolute return strategies in London. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.