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Deflation, not inflation, is the main risk now

In recent weeks, unprecedented monetary and fiscal measures by central banks and governments have contributed to restoring order in developed bond markets. As investors adjust to the new paradigm, senior investment strategist Daniel Morris discusses the prospects for fixed income markets with Dominick DeAlto, chief investment officer fixed income.  

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What are the prospects for inflation in developed economies?

Dominick: In the short term, we believe that deflation – not inflation – is the main risk. Longer term, it is conceivable that structural forces could drive inflation rates higher, but this year we see deflation as the main risk.

Here are some reasons why:

  • Oil prices have collapsed. Diesel and petrol represent 3.5% of the basket of goods and services that make up the US consumer price index (CPI). Low prices for oil – and for commodities more generally – following the shutting down of a significant part of the global economy will likely keep consumer price inflation very low for at least the next year.
  • Data is already showing falls in prices of goods at the factory gate – producer price inflation (PPI) – as prices of input materials fall. Lower costs for producers will result in lower prices of goods.
  • Many companies are heavily discounting prices to sell off inventory and raise cash to cover their running costs. We expect this to continue as restrictions are lifted because businesses will need to tempt consumers back into their stores using lower prices.
  • Rising prices in sectors such as groceries and medical goods and services will be outweighed by falling prices in other sectors facing a collapse in demand.
  • Lastly, 30 million jobs – an entire decade’s worth of gains – have been lost in the US over the last six weeks. Wage disinflation is now a concern. There is already anecdotal evidence of companies seeking to reduce costs by lowering wages. Lower wages means lower production prices and ultimately lower retail prices. This is another example of the sort of negative feedback loop that adversely impacts inflation psychology.

Exhibit 1:

Over the long term, there are structural reasons that could lead to a rise in the rate of inflation. Central banks have monetised an enormous part of countries' national debt and with a major expansion of government spending programmes coming up, they will probably have to continue printing money for the foreseeable future. Further ahead, this money will end up either in higher asset prices, or rising consumer prices, or even both.

In addition, we expect some de-globalisation as key industries are repatriated, supply chains no longer route through China, and national champions are protected. All that will reduce competition, raise production costs and lead to higher prices.

In conclusion, longer term (i.e. 18 months from now), we could see some inflationary pressures, but near term, it’s deflation, in our view, that will be the main risk.

Have recent events in the US helped or hurt market liquidity?

Dominick: The US Federal Reserve (Fed) took unprecedented measures in April. They completely changed the environment for US corporate debt markets. The measures included what is a virtually unlimited purchase programme for investment-grade corporate bonds.

In addition, the Fed is now buying high-yield bond exchange traded funds (ETFs). Prior to their intervention, liquidity for these funds had evaporated such that they were trading at a previously unseen discount to the value of their assets.

Multiple main-street lending facilities have also been created to lend directly to small businesses and programmes originally created after the Global Financial Crisis restarted to inject liquidity into just about every sector of fixed-income markets, with corporate debt a particular target.

On the fiscal side, Congress has already passed relief packages amounting to around USD 3 trillion in response to the pandemic, but the scale of the devastation means lawmakers are now preparing a fourth tranche of aid.

All these monetary and fiscal measures have created a backstop for bond markets, especially corporate debt. As a result, valuations of US investment-grade corporate debt have retraced around one third relative to the highest point risk premiums reached back in March. High yield has also recovered, though of course not to the same extent, as it includes the least robust corporate debtors.

Liquidity has improved considerably compared to the conditions we saw in March, when trading in some sectors of the US bond markets almost seized up. Bid/offer spreads for US investment-grade corporate debt are still elevated but no longer prohibit trading. Some two-way flow has returned to corporate debt markets but only for the most liquid issuers. Those sectors most exposed to the economic consequences of this pandemic, such as energy or retail, remain highly illiquid. Liquidity is currently selective.

The investment-grade debt market has been the chief beneficiary of the Fed’s stimulus efforts. March saw a record-breaking USD 234.7 billion of new issuance, as the shutdown of the US economy left many businesses in dire need of cash. Borrowing slowed slightly in April but remained above the USD 200 billion level.

High-yield debt issuance has risen as well. There was around USD 33 billion worth of junk bonds issued in April (compared to USD 3.5 billion in March and USD 16 billion in April last year) according to Refinitiv IFR and SIFMA data.

What is your analysis of recent US economic data?

Dominick: Last week’s release of data for US gross domestic product (GDP) showed the US economy shrank at a 4.8 % annualised rate in the first three months of the year. That marks the steepest drop since the 8.4% contraction at the end of 2008. It was worse than the consensus forecast for a 4% decline in output.

In addition, the scale of the impact on the American consumer, the biggest driver of US economic growth, was illustrated by a 7.6% drop in personal consumption for first quarter 2020 (healthcare accounted for 40% of the fall with transportation, recreation, food services and accommodation also suffering sharp declines). This is very disappointing data – it is the biggest decline since 1980.

It is, however, far too early to draw any conclusions from this data. GDP is a backward-looking indicator. Data for the second quarter is likely to be much worse as US lockdowns only began in earnest in mid-March.

In terms of the process of assessing the economic impact of the pandemic, we are in the very early stages. As investors, we know little about the full micro- and macroeconomic consequences.

We have a long list of unknown variables. Currently, we don’t know how long economies will remain paralysed. Nor can we fully assess the extent of de-globalisation. We do not yet have an accurate timeframe for comprehensive testing – arguably a critical requisite for relaxing restrictions. How will the consumer react when the lockdown ends?

In light of this backdrop, we remain cautious. The recent rally in risk assets was largely fuelled by the news about monetary and fiscal policy rather than any positive developments regarding the pandemic or the economy.

Our investment activity is now primarily focused on corporate debt, where the backstop policymakers have created has given rise to a number of attractive opportunities. Corporate debt markets have the potential to generate attractive returns in the coming months as the yield pick-up they offer over sovereign debt remains significant.


Any views expressed here are those of the speakers as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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