27 May 2021
14/05/2021 | Tim Foster, Portfolio Manager
With the latest US inflation release representing the highest year-on-year increase since 2008, portfolio manager Tim Foster analyses whether a more inflationary environment could be here to stay. He outlines what this means for fixed income investors and highlights the current opportunity in inflation-linked bonds.
Key points
US headline Consumer Price Index (CPI) inflation rose by 4.2% - the fastest pace in 13 years on a year-on-year (YoY) basis - driven by the reopening of the world’s largest economy. Although some of this can be explained by positive base effects and rising energy prices, the core CPI, that excludes food and energy, still expanded by 3% on the year before.
There was a rapid rise in the prices of both goods and services in April, where categories linked to the reopening were particularly strong. Core goods inflation was 4.4% YoY in April, driven by the prices of used cars and trucks which expanded by 21%.
Core services inflation rose too, to 2.5% YoY, supported by hotels and airfares. Goods price rises are likely to be more transient as supply chain issues fade, with history showing that economies are quite quick to respond to supply chain issues. The area to watch for us now is services inflation, which had been falling prior to March and April this year.
Rapid reopening drives inflation higher
Source: Fidelity International, Bloomberg, 12 May 2021.
With holidays and haircuts largely off the cards until now and social distancing measures in place, services inflation has languished of late. This stands in contrast to the decade before the pandemic, when the core services CPI rose on average by 2.4% per year while core goods inflation was a mere 0.1%.
Although there was deflation in both goods and services last spring, the price of goods swiftly recovered as people shopped online and supply chain and capacity constraints pushed up raw material inflation. Last December, goods inflation eclipsed that of services for the first time since 2011. Although goods inflation remains notably higher, services inflation seems to have turned a corner.
We expect services inflation to be less volatile and more sustained, as record levels of personal savings and the reopening of economies mean that households can spend on holidays and eating out. This should result in a more sustained increase in prices than the concentrated burst in goods inflation.
Strong house purchase prices should also support rental prices, which make up about half of core services CPI. Core services in turn account for 59% of CPI. That is a far higher proportion than core goods, which only make up a fifth of the inflation basket. This means that any further rise in services inflation could have meaningful implications for overall US price levels in the months ahead.
While a significant rise in inflation is harmful to fixed income investors, inflation-linked securities can work as a hedge against the loss in purchasing power, by offering real returns. Global inflation-linked bonds also offer diversification benefits, relative value opportunities, and can be a partial hedge against rising rates.
Nevertheless, investors still need to pick the optimal maturities, because different segments come with their own risks. Across our portfolios we prefer the 1-to-10 year part of the market, which we see as not too long and not too short.
Relative to longer-maturity indices, the 1-to-10 years segment helps to isolate inflation risk and reduce duration risk. We also prefer this part of the market over shorter-maturity indices, which expose investors to the more volatile components of inflation (for example, oil price movements) and less enticing valuations.
By focusing on the middle path, the 1-to-10 year segment of the inflation-linked bonds market can help investors hedge against further inflation at relatively attractive valuations.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers. Fidelity’s fixed income range of funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes.