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Has the rally in inflation-linked bonds (also called linkers) run out of steam? Depends on who you ask. As domestic inflation remains elevated and amid the sombre outlook for global price increases some fund managers have opted for the surety of guaranteed real returns that is now on offer by linkers.
The performance of linkers is intrinsically tied to that of price increases in the economy. Governments don’t like to issue them, and do so in smaller quantities than they issue nominal bonds, which don’t pay a fixed interest rate above the consumer price index (CPI) (the latter in SA’s case). Governments like to bet on inflation gnawing away at the purchasing power of the issued debt over time.
Nevertheless, linkers are a sought-after asset especially for financial companies that need to match their liabilities with assets. Life insurers are an example, Bronwyn Blood, portfolio manager at Granate Asset Management, explains to IM. “[Linkers are] also a great asset for income funds,” she says. “Income funds need to protect their underlying capital from inflation, and linkers are assets with no risk of inflation eroding capital over time.”
This results in a situation of life insurers and providers of life annuities creating a strong demand for linkers. Add the fact that balanced funds will also try to protect some of their underlying assets from the perils of inflation, and one can easily understand that linkers have had a good run lately.
The S&P SA sovereign inflation-linked bond index returned a healthy 6.41% over the 12 months to July 8. The gauge reached a record high on June 3. The 12-month return compares with the local CPI of 6.5% per year that was recorded in May — thus a real return of about 2.59 percentage points.
The outlook for inflation, both domestically and around the world, remains dire. In the US inflation quickened to 8.6% in May — a 40-year high. In the EU, the gauge came in at 8.1% — also a record. In China, SA’s largest trading partner, annual inflation reached 2.1% in April — the highest since November. The outlook for inflation there isn’t too great either.
As Swiss lender UBS said in a research note in May: “Other changes in long-term trends suggests higher inflation in the future. The era of globalisation is ending, while government intervention is on the rise. Both trends are likely to be inflationary.
“Regarding globalisation, in 1945 global trade was 10% of [global] GDP and by 2008 it was 61%. But it has been declining ever since. Just-in-time supply chains with their emphasis on maximum efficiency and minimal costs came along with globalisation, lowering global inflationary pressures. However, systems which are maximally efficient can be fragile.”
With the Chinese government’s zero-tolerance policy towards resurgent Covid cases and the continuing Russo-Ukrainian war, global supply chains may remain under pressure for a time to come. The Federal Reserve Bank of New York said in mid-May, when it released its global supply chain pressure index for the month: “The worsening of global supply chain pressures in April was predominantly driven by the Chinese ‘delivery times’ component, the increase in airfreight costs from the US to Asia and the euro area ‘delivery times’ component.
“These developments could be associated with the stringent Covid-19-related lockdown measures adopted in China, as well as the consequences of the Ukraine-Russia conflict for supply chains in Europe.”
On June 7, the World Bank warned that the risk of global stagflation has risen sharply. In its “Global Economic Prospects” report, the international lender says global growth “is expected to slump from 5.7% in 2021 to 2.9% in 2020”. That is an almost halving of its growth outlook. For SA, the bank estimates meagre real GDP growth of 2.1%.
In the near future, the bank is worried that inflation will “become baked into wage- and price-setting behaviour”.
“There are material risks that inflation could rise higher or remain elevated for longer than currently projected,” the World Bank report states. “If supply disruptions persist or commodity prices continue to climb — in the event of a protracted war in Ukraine, for example, or recurring pandemic outbreaks and movement restrictions in China — inflation could remain above central banks’ target ranges in many countries.”
With SA being an importer of machinery and oil, the prospect of imported inflation is becoming a real threat to local prices. The price of 93-octane unleaded petrol (in Gauteng) has already jumped by 36% since the beginning of the year.
Worryingly, local inflation expectations have risen above the Reserve Bank’s midway inflation target point of 4.5%. At its May meeting, when it raised interest rates by 50 basis points to 4.75%, SA’s monetary policy committee said: “Average surveyed expectations of future inflation have increased to 5.1% for 2022 (from 4.8%). Expectations for inflation, based on market surveys, have increased to 5.9%. Long-term inflation expectations derived from the break-even rates in the bond market have also increased.”
This bodes ill for wage negotiations. Sibanye-Stillwater, for example, said on June 13 that it will increase wages for its least-paid employees by an above-inflation 7.7% this year. Eskom hiked salaries by 7% earlier this month. Unions in the public sector demand a 10% increase in pay, renegotiable every year. This has led to a deadlock in negotiations with the government. Add to this a 9.6% increase in Eskom’s tariffs in April, and the outlook for SA inflation is sticky.
The rand remains the unknown variable that may put pressure on the accelerator as central banks in developed markets start to raise interest rates at a quicker pace.
“The minutes from the June Federal Open Market Committee (FOMC) meeting were largely in line with our expectation for further significant policy rate firming at the July and September FOMC meetings,” Ethan Harris, head of global economics at BofA Global Research, wrote in a July 8 note to clients. “While committee members view imbalances between supply and demand as leading to widespread inflationary pressures, the Fed sees supply-side factors as likely to persist, particularly in the areas of pandemic-related supply constraints and subdued labour force participation. Hence, to bring inflation back in line with the Fed’s 2% mandate over time, the Fed views a slowdown in aggregate demand as necessary.”
In such a gloomy inflation-racked world, linkers become a benevolent hedging tool. “Linkers provide a high real yield [as shown by] its history,” Blood says. As a result, she opts for linkers on the short side of the curve, or those with a short maturity.
Sumesh Chetty, portfolio manager at Ninety One, says that in its simplest form linkers are a long-term hedge against inflation. Linkers sit on a 3.5% real yield at present. Though the S&P inflation-linked index had a good run over the past 12 months, some bond investors may be mindful of a harsh reckoning in 2020. That year the move in real yields was 100 basis points upwards, says Chetty. “That meant a painful 7% hit to returns.”
That move coincided with the March 2020 Covid-induced economic and market crashes which evaporated consumer demand and subsequently brought about a steep drop in inflation. Ever since, though, the linkers index had a steady return and performance.
Not all bond investors are eager to jump into linkers. “I don’t like them,” says Nolan Wapenaar, chief investment officer at Anchor Capital. “They make sense in two instances. First, when they’re cheap and pay a nice income, which is not the case now. Second, when inflation is rising and [globally] central banks will crush inflation.” Wapenaar holds that SA’s linker rally has run its course. “Buying them now is like fighting the Fed.”
Still, Blood says you can look at the real yield on linkers — as a quasi-proxy, almost, for real GDP growth. This is because the real yield on linkers reflects the real short path on interest rates, which in turn depends on the outlook for GDP growth and inflation. Investors will at present receive a premium to SA’s GDP growth outlook in the linker space.
GDP growth also strips out the effect of inflation and gives a real reading of growth. With the yield on 10-year linkers at about 3.75% and SA’s long-term growth forecast looking closer to 2%, investing in linkers brings a significant premium against the long-term growth outlook with the benefit of inflation protection. This seems like a very attractive proposition in the current environment, in which inflation is causing such upheaval in markets and everyone is running scared.
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Published by Arena Holdings and distributed with the Financial Mail on the last Thursday of every month except December and January.