Invesco: The inflation debate and the market implications

In the 20 odd years that I have been in the financial markets, inflation has rarely ignited as much debate as it is doing right now. I see that in meetings across the Henley investment floor and in numerous blogs and research pieces written by Invesco colleagues worldwide.

With seasoned veterans of disinflationary and - dare I say it - inflationary environments within the Henley Fixed Income team, the discourse on inflation on daily calls and in strategy meetings can also get quite lively. What we all agree on is that the pandemic, in addition to its human toll, will likely have a profound impact on the economic and policy landscape for years to come which could end up being inflationary. It's not a prediction but it is a clear risk given the unprecedented amounts of past, present and likely future levels of fiscal and monetary support in the system.

Our desk economist Mark McDonnell wrote an introductory piece framing the academic debate. In summary, he puts forward three arguments that 'lean' towards suggesting that this time may be different and that it could be wrong to assume that future inflation will be anchored by past disinflationary experience. I say 'lean' because nothing is definitive and it is easy to have sympathy with both sides of the inflation debate.

Bringing it back to markets, as fund managers we must make judgments and investment decisions in the context of valuations. Our collective view, as implied above, is that the unprecedented policy response to Covid-19 raises medium to longer term inflation risks. Before outlining what we have been doing in some of our funds related to this theme, it is worth recapping on recent performance of inflation-linked bonds.

Recent Performance

To get slightly technical, the expected return on an inflation-linked bond can in simple terms be thought of as a real yield (coupon) and an inflation adjusted element of both coupon and principal. For valuation purposes, we tend to look at the 'real' yield and the breakeven inflation spread which is the difference between the nominal yield on, for example, a 10-year US Treasury security, and the yield on a 10-year Treasury Inflation-Protected Security (TIPS). While not perfect, that breakeven spread gives us some idea of what the market is expecting on average for inflation over the remaining maturity of the bond.

The long-term chart below shows that 10-year inflation expectations (the breakeven rate) cratered in March, much as it did during the great financial crisis. In both cases there was a genuine collapse in inflation expectations owing to sharp falls in economic output, but there are also ‘market technicals’ at play too such as diminished market liquidity. Generally, risk-off environments are not good for inflation-linked bond markets. This time around the collapse in breakeven rates back in March was exacerbated by a sharp fall in the oil price as global oil demand collapsed and OPEC talks broke up without agreement on mitigating supply constraints.

Fund Strategy

As mentioned above, the inflation debate is right up there in the list of topics discussed by the wider Henley Fixed income team. Hence it should be no surprise that several fund managers have made some allocation to inflation-linked securities.

The Invesco Global Bond Fund (UK), for example, already held a reasonable position in US inflation-linked securities pre-Covid. This was in recognition of a more dovish monetary policy environment and the potential shift towards average inflation targeting which would see the US Federal Reserve keep policy loose for longer. That strategy had been gathering some momentum in Q4 last year prior to the outbreak of Covid. The collapse in the inflation-linked bond markets in March was indeed brutal but we have since added to our exposure both outright and by extending across the TIPS yield curve to gain exposure to longer maturities. Put another way, we prefer to be invested in US inflation-linked securities than conventional US Treasuries. As at 30 June 2020, the fund held 24.6% in US TIPS and no conventional US Treasuries.

The Invesco Tactical Bond Fund (UK), had also built a position in US TIPS, increasing the position in January by switching from conventional US Treasuries. As at the end of June the fund held 4.5% in US TIPS, while still holding 6.0% in conventional US Treasuries. Both these figures have been reduced over recent months, from 8.0% and 19.2% respectively at the end of February, as credit risk has been added to the portfolio following the significant spread widening seen in March and April.

In summary, even after the recent outperformance of inflation linked markets, while we may get a period of consolidation or even a slight reversal in performance, we still see value on a longer-term structural view. In these exceptional times, we think it is prudent to have some inflation protection.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange-rate fluctuations) and investors may not get back the full amount invested.

Invesco Global Bond Fund (UK) - Please refer to the risks numbered 1, 3, 6, 7 and  8

Invesco Tactical Bond Fund (UK) - Please refer to the risks numbered 1, 2, 4, 5, 6 and  7

1. The securities that the Fund invests in may not always make interest and other payments nor is the solvency of the issuers guaranteed. Market conditions, such as a decrease in market liquidity for the securities in which the Fund invests, may mean that the Fund may not be able to sell those securities at their true value. These risks increase where the Fund invests in high yield or lower credit quality bonds.
2. As the fund can rapidly change its holdings across the fixed income and debt spectrum and cash, this can increase its risk profile.
3. The fund has the ability to make use of financial derivatives (complex instruments) which may result in the fund being leveraged and can result in large fluctuations in the value of the fund. Leverage on certain types of transactions including derivatives may impair the fund’s liquidity, cause it to liquidate positions at unfavourable times or otherwise cause the fund not to achieve its intended objective. Leverage occurs when the economic exposure created by the use of derivatives is greater than the amount invested resulting in the fund being exposed to a greater loss than the initial investment.
   
   The fund may be exposed to counterparty risk should an entity with which the fund does business become insolvent resulting in financial loss.
4. The fund has the ability to make significant use of financial derivatives (complex instruments) which may result in the fund being leveraged and can result in large fluctuations in the value of the fund. Leverage on certain types of transactions including derivatives may impair the fund’s liquidity, cause it to liquidate positions at unfavourable times or otherwise cause the fund not to achieve its intended objective. Leverage occurs when the economic exposure created by the use of derivatives is greater than the amount invested resulting in the fund being exposed to a greater loss than the initial investment.
   
   The fund may be exposed to counterparty risk should an entity with which the fund does business become insolvent resulting in financial loss.
5. The Fund may invest in contingent convertible bonds which may result in significant risk of capital loss based on certain trigger events.
6. The fund’s performance may be adversely affected by variations in interest rates.
7. The fund has the ability to invest more than 35% of its value in securities issued by a single government or public international body.
8. Although the Fund invests mainly in established markets, it can invest in emerging and developing markets, where there is potential for a decrease in market liquidity, which may mean that it is not easy to buy or sell securities. There may also be difficulties in dealing and settlement, and custody problems could arise.

Important information

All data is as at 30/06/2020 and sourced from Invesco unless otherwise stated.

Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice. This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.

For the most up to date information on our funds, please refer to the relevant fund and share class-specific Key Investor Information Documents, the Supplementary Information Document, the Annual or Interim Reports and the Prospectus

Stuart Edwards
Fund Manager