By Lyxor Asset Management.

Two ways to position your portfolio for a rise in inflation

It’s one year since the pandemic shut down large parts of the global economy. Now, hopes that mass vaccination will accelerate economic normalization have raised the prospect of inflation.

Below we look at some potential drivers of inflation, and how investors can position themselves to benefit.

The global economy is en route to recovery

Inflation prints fell at the height of the Covid-19 crisis, as demand collapsed due to lockdown restrictions and oil prices plunged. The trajectory of economic recovery remains uncertain, but a global recovery is undeniably taking shape, demonstrated by the subsequent sharp rebound in global PMIs. Inflation has been gathering momentum since the second half of 2020, in both the US and Europe.

Will inflation continue to rise?

Whether the ongoing normalization in prices can be sustained over the long term is a source of heated debate. For now, inflation expectations have built up, but ultimately, a sustained pick-up in inflation will have to be supported by higher incomes.

Central banks will also play a major role in determining inflation’s trajectory. The US Federal Reserve looks likely to maintain an accommodative bias and wait for a substantial increase in inflation before taking action. Current market expectations are for Fed tapering to start late this year or early next, with no rate hikes expected before 2023.

That said, it’s extremely difficult to predict the inflation rate over the year ahead, as the pandemic has dramatically changed the landscape for developed countries. The inflation outlook relies on governments’ ability to support local economic activity, while expansive fiscal policies will play a major role in helping determine a new inflation baseline.

So what are our predictions?

In the short term, we believe the ongoing recovery in energy prices and global activity should support inflation. However, underlying domestic price pressures are likely to remain contained for now, particularly in sectors such as airlines and hospitality which still suffer from activity restrictions. Over the longer term, increasing budget deficits and escalating debt-to-GDP ratios could weaken currencies, supporting a rise in inflation. A continuation of the reversal of globalization that started with the US-China trade war could also see prices rise further.

How can investors profit from an increase in inflation?

If you’re expecting inflation to rise, you have various options available to you.

Two of the best ways of profiting from rising prices are by investing in inflation-linked bonds – bonds whose coupon payments rise or fall in line with inflation – or inflation expectations strategies – which aim to provide exposure to the inflation breakeven rate (the difference between nominal bond yield and those of inflation-linked bonds).

Which is the better option? That depends mainly on your outlook for inflation. Inflation-linked bonds are the conventional choice, but inflation expectations strategies may perform better at times when markets are underestimating just how high inflation could go. And crucially, thanks to their close to neutral duration, Lyxor’s inflation expectations strategies won’t suffer from the negative effect of rising yields on the price of underlying bonds.

Let’s take a look at some of the things that investors need to consider when allocating to these different types of investment.

Inflation-linked bonds

Investors need to assess several factors when considering how to allocate to inflation-linked bonds. These include:

• The pace of activity (business surveys, etc.)
• Inflation expectations (inflation breakeven rates)
• Headline inflation drivers (e.g. the oil price)
• The outlook for central banks’ action (the slope of the yield curve)

Analyzing these factors will help you assess which countries to allocate to in a global portfolio, as well as deciding the appropriate duration risk exposure to take. But you also need to remember that the structure of inflation-linked bond markets can vary a lot from one country to another.

For example, the US inflation-linked bond market has a duration of 8.2 years, slightly above the average duration of 6.9 years for Treasuries. But the average duration of UK inflation-linked bonds is much higher – close to 21.1 years, while that of Gilts is around 12.6 years.

This has big implications for investors. The longer until a bond matures, the higher its duration and the amount its price will fall when real bond yields rise. As a rule of thumb, every 1 basis point rise in interest rates will knock 1 basis point off the capital value of a bond per year of duration.

The long duration of the UK inflation-linked bond market means that its contribution to duration risk in a global inflation-linked bond portfolio will be higher than its market value weight. One way to reduce this risk is to constrain your exposure to a narrower set of maturities (for example, 1–10-year bonds) rather than taking an all-maturity exposure.

Inflation expectations strategies

Inflation expectations indices are designed to capture changes in the breakeven inflation rate – the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity. To do so, a basket of inflation-linked securities is bought while a basket of treasuries with matching maturities is sold, on a daily basis.

Due to the non-linear relationship between changes in yield, return and fluctuations in market supply and demand, the magnitude of inflation expectations strategies movements relative to changes in breakeven inflation can vary. But again, there are some useful rules of thumb.

For example, we’ve found that a US inflation expectations strategy will move by approximately 8 basis points for every 1 basis point absolute change in the underlying breakeven inflation rate. This sensitivity is closer to a 4bp change for a strategy sensitive to eurozone inflation expectations due to the more complex structure of the inflation-linked bond market in the eurozone.

Cherry-pick your inflation exposure with Lyxor

At Lyxor we’re proud to be able to provide you with one of Europe’s largest and most extensive ranges of inflation-linked bond and inflation expectations strategies to help you fine-tune your portfolio’s inflation exposure. Take a look at our offering in the table below.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)