• Energy prices have clearly collapsed, and this will pass through into petrol and heating oil prices.
• Food prices are likely to rise as the cost of production and distributions will increase given the public health restrictions.
• Prices of most core goods will soften as retailers mark down prices to maintain sales and reduce inventories. In other categories, prices could rise if there are supply shortages due to manufacturing and distribution shutdowns (electronic equipment, for example).
• There could be CPI data collection difficulties for many categories and services. In that case, the index for that category will be unchanged or based more on internet-based prices. For some categories, an unchanged CPI index will actually overestimate the true rate of inflation.
Over the next few quarters, the impact of a severe recession is likely to be disinflationary. Public health measures and uncertainty throttle
- aggregate demand:(workers lose income if they don’t work and opportunities to consume if they are confined
- aggregate supply: businesses cannot and will not produce without workers or orders.
Overall, however, we would expect the slump in demand to overwhelm the decline in supply, and for inflation to fall. Core goods prices will likely move further into negative territory, while core services prices will soften, but be robust enough to keep overall core consumer price inflation positive.
Longer term, a reversal of globalisation will be inflationary
In the longer term, however, as aggregate demand recovers, we could see the economy push up against capacity constraints given the damage done to potential output.
Furthermore, it seems highly likely that pre-existing international trade tensions as well as concerns over the resilience of highly connected global supply chains in an age of pandemics and great-power rivalries will result in a lurch towards protectionism.
A striking example of such protectionism is the current push for each developed country to produce its own respirators, with different designs. One can imagine that after the crisis, many industries and products will be designated as critical to national security, with governments supporting domestic producers. Ultimately, this reversal of globalisation should be inflationary, limiting competition as it does.
But the age of the internet will continue to limit inflationary pressures
Politically, it looks highly likely that electorates whose financial fragility will have been exposed by a mandated lockdown will demand changes to the current economic structure in which wealth and incomes have become so concentrated. On the one hand, higher wages and more generous healthcare benefits are inflationary. On the other hand, we cannot deny the potential for automation, technology and price transparency in the age of the internet to continue to limit inflationary pressures.
How do we position in eurozone inflation-linked bonds?
The market will likely remain nervous about the impact of COVID-19 on public finances, bond issuance, debt sustainability and sovereign credit ratings.
In an optimistic scenario, economic shutdowns end and growth rebounds faster than anticipated, EU leaders enact a coordinated response to mutualise fiscal costs and the ECB looks beyond the immediate rebound and continues its asset purchase programmes.
If this scenario materialises, we should see core government bond yields rise as the market prices in the improved outlook for inflation and growth. ‘Peripheral’ bond spreads will tighten as the harder-hit southern European countries benefit from the improved political cohesion in the eurozone and the ECB’s liquidity support. Inflation will likely bound back faster from the current sub-zero levels as the disinflationary impacts of the coronavirus crisis fade away, driving breakeven inflation rates higher.
At the other end of the spectrum, in a pessimistic scenario where a deepening recession is not met by decisive solidarity financing to help the more vulnerable EU countries to fight the crisis, the weaker member states could face sovereign credit downgrades.
The political division within the eurozone could grow and nationalism could return. Investors will worry increasingly about a re-emergence of euro breakup risk. Core government bonds, particularly German Bunds, will likely rally as investors flock to safety amid the higher risks of debt redenomination.
‘Peripheral’ bond yields will skyrocket, especially if Italian debt is downgraded to below investment-grade. Inflation-linked bonds will likely underperform as questions over what the bonds’ linkage to euro HICP inflation really means find no immediate answers.
Government bond yields are likely to stay low in the eurozone
We expect an outcome somewhere between the two extremes. Concerns over a second wave of infections, still limited testing and surveillance capacity and insufficient medical supplies suggest that governments would be careful to relax containment measures.
Some degree of social lockdowns will likely persist. A V-shaped economic recovery is therefore unlikely. EU member states will continue their marathon discussions about a compromise on how to finance the economic reconstruction. The poor economic and inflation outlook, combined with the ECB’s asset purchase programmes, will keep government bond yields low, and the risk premiums on ‘peripheral’ bonds contained.
Deflationary impact of demand destruction to overwhelm inflationary effects
With ‘peripheral’ risk premiums still relatively tight on an historical basis, and the risk of redenomination concern re-emerging not insignificant, we believe the risk-reward of owning ‘peripheral’ eurozone bonds for carry purposes is unattractive.
As such, we will continue to look for opportunities to exit our ‘peripheral’ bond positions. We are maintaining an underweight bias in eurozone breakeven inflation since we expect a deflationary impact from demand destruction to overwhelm supply-side inflationary effects in the near to medium term.
This is an extract from the Inflation-Linked Bond Review & Outlook March 2020
Any views expressed here are those of the author 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.