As the author mulled through reams of research notes on disinflation, deflation, and policy rates, he thought of one of his all-time favourite songs, Mad World by Tears for Fears, released in 1983. Reflecting on negative bond yields, and rates that had been stuck at rock-bottom levels for years, the song attained a financial market meaning.
QUICK FACT: ”Japanification” is a term used by economists, derived from the events which led to and resulted from the "the lost decades” (since the early 1990s) of the Japanese economy. “The bubble burst, people became cautious and the economy got stuck in too low a gear to stop prices and interest rates from falling.” The Economist, 22 August 2019.
Much of what is written in this article is well telegraphed, and has arguably been examined to death. Be that as it may, it is worth taking stock of the new-found financial market madness to obtain a more holistic picture of exactly what we are dealing with.
Global inflation rates have been low for a while in many regions
Source: Bloomberg, Futuregrowth
So, how did we get here?
Is this really such a mad “inflation world”? More importantly, how would a permanently changed inflation world impact our investment thinking – and would the perceived relative attractiveness of nominal and real interest rate bearing assets change?
At the time of writing, twelve (mostly European) countries were offering government bonds with a term to maturity of seven years and longer, at near-zero and negative yields. This includes countries like Portugal and Spain that, not that long ago, formed part of the infamous PIIGS grouping that faced significant fiscal and economic challenges (Ireland, Italy and Greece were the other three countries). What exactly got us to this seemingly semi‑permanent new realm?
Our default mode
The role played by sustained low inflation in the aftermath of the 2008 financial crisis, specifically the inability of central banks to reflate their respective countries, is particularly noteworthy. Most fixed-income investors are still more comfortable with a “normal” world in which inflation erodes the purchasing power of the future cash flows of a fixed-rate bond. In this “normal” world of inflation, we would demand a higher yield for holding longer-dated bonds, to offset some of the expected risks to our and our clients' future purchasing power. Alternatively, we would simply protect this purchasing power by investing in inflation-linked bonds. In the developing world, relatively fresh memories of violent inflation spikes still enforce a “default” mode of looking for opportunities to purchase inflation protection.
When most investors expect a sustained period of disinflation or even deflation, then the realm of low and even negative yields presents itself. So, investors in many developed markets have simply stopped viewing inflation as a threat to the future purchasing power of their investments. By implication, these investors view current policy efforts to reflate economies, particularly from the monetary side, as ineffective and perhaps even irrelevant. Given the Japanese experience and other more recent examples, who can blame them?
Central bank policy rates: too many still stuck on the floor?
Source: Bloomberg, Futuregrowth
Instead of investing in bonds with the primary objective to gain access to a steady, inflation-beating cash flow or income stream, policy-sceptics opt to invest in bonds trading at negative yields. They do this with an eye on the perceived relative safety of these bonds (negligible default risk) or in the hope of yields sinking deeper into negative territory, which will deliver capital gain to the holder of the negatively yielding instrument. Some would call this behaviour fixed-loss as opposed to fixed-income investing.
No simple answer
Of course, the phenomenon is not only a function of disinflation and suppressed inflation expectations. The role of quantitative easing, that is, the large-scale buying of government bonds across all maturities by central banks in the aftermath of the global financial crisis, also had an important role to play. This additional demand had the sole intention to drive market yields as low as possible in a desperate attempt to inflate economies. The general view at the time was that this madness could easily be reversed as soon as economic conditions normalised. Nevertheless, the situation proved to be a lot more complex than most anticipated when these “solutions” were presented.
This makes us wonder why authorities in so many developed markets are struggling to get inflation to rear its head after so much effort and over such an extended period. As it turns out, it seems notoriously difficult to change entrenched expectations. For instance, it took drastic action to break the back of the high inflation expectations of the ‘70s and ‘80s.
What is inflation in any case?
In a special report titled, “The Case Against Secular Stagnation”, the research firm, The Bank Credit Analyst, showcased the United Kingdom consumer price data stretching as far back as 1688. Prior to the late 1940s, and except for a few spikes around periods of war, the United Kingdom experienced near-zero inflation for centuries.
Who says that the globe, apart from the usual tail-risk countries, is not bound to return to the long-term norm? If so, then the sustainability of asset classes such as inflation-linked bonds, the existence of which is attributed to the phenomenon of inflation, should rightfully be questioned. (This issue will be addressed in more detail in a follow-up article.)
Inflation is a relatively recent phenomenon
Source: The Bank Credit Analyst: “The Case Against Secular Stagnation”.
Another enduring question is whether the phenomenon of inflation is correctly captured by statisticians. The author’s wife keeps reminding him about “shrinkflation”, which she demonstrates by way of real-life examples, such his favourite late-evening snack. She has noted with dismay that, over time, his ice-cream is sold at the same price, but in an ever‑shrinking container. In other words, the manufacturer has opted to shrink the unit of ice‑cream while keeping pricing constant, as opposed to increasing the price per unit of ice-cream.
Complexities of measuring price changes
With the onset of online shopping, concepts such as “quantum-pricing” have also added to the complexity of accurately measuring the direction and rate of price changes. To learn more, refer to the article, “Free exchange/Cut-price economics” (page 58), featured in The Economist of 10 August 2019. The same publication released an excellent special report (in this authors opinion) titled, “The end of inflation?” in its 12 October 2019 publication. I would encourage readers to take the time to look at the special report as it covers this topic well.
As a small, open economy, South Africa is not left in the cold with respect to the persistent, strong disinflationary forces that many of its main trading partner countries are experiencing. The country’s relatively well-behaved rate of inflation attests to this, both at producer and consumer levels, despite significant currency weakness since 2011. Of course, this is not the sole driver. Sub-potential economic growth, the inability to pass price increases on to the end consumer, technological advances and sensible monetary policy have all contributed to a stable inflation backdrop. With the consumer rate of inflation below the mid-point of 4.5% of the target range, the South African Reserve Bank (SARB) had sufficient reason to cut the repo rate earlier this year.
Currency impact on local inflation has weakened significantly since 2011
Source: Bloomberg, Futuregrowth
How does this impact our thinking on local market valuation?
Let’s begin with the easily digestible parts. Even though inflation is well behaved, especially considering South Africa’s volatile inflation history, the SARB is still focused on containing inflation, unlike many of the bank’s counterparts in the developed world. If anything, the SARB’s prudence in remaining an inflation hawk should be supported. Inflation hurts the poor most – period!
The dismal backdrop to economic growth is mostly structural. A low real rate is not an easy fix. That said, reduced price sensitivity to currency volatility also implies increased monetary policy stability. In turn, this lends stability to the front end of the nominal yield curve.
The latter is powerful, especially in the case of a positive yield curve slope. With a benign inflation outlook, reduced inflation volatility, and a decline in the previously strong positive correlation with rand exchange rate volatility, one may ask: why the steep yield curve slope? The main reason seems to be related to rising concerns about the fiscal path the country is travelling along, its direct (and quantifiable) impact on the funding requirement and sovereign creditworthiness. It is simple: if the perception of credit quality drops, then the risk/reward principle dictates a higher required yield. And the further out onto the yield curve you wish to wander, the higher the level of uncertainty, and thus the required risk premium and yield.
Our current view
Considering the combination of the above, where do we see the best value? Our latest interest rate view is best illustrated by our more flexible bond offering, where we have more freedom with the allocation between the three interest rate bearing asset classes. Despite long-held grave concerns about the slippery fiscal path, and thus the creditworthiness of the South African government, this fund has an overweight position in nominal bonds. Since gearing is not allowed, this overweight position is “funded” by underweight positions in both cash and inflation-linked bonds.
What are the reasons for our allocation?
- The front end of the nominal yield curve is anchored by stable monetary policy, due to a relatively benign inflation outlook and weak economic growth. As discussed above, the correlation between volatile exchange rate movements and inflation has weakened somewhat since mid-2011.
- The 10-year and 30-year points on the nominal yield curve are offered at very attractive inflation-adjusted real yields of 5% and 6%, respectively. This is particularly enticing considering our 12-month inflation forecast is at an average rate of around 4.8%, from 4.1% currently.
- Inflation breakeven levels are currently significantly higher than our inflation forecast, more so in the case of higher convexity inflation-linked bonds. This clearly guides favour to nominal, as opposed to inflation-linked, bonds.
- The nominal and inflation-linked bond markets are equally impacted by the slippery fiscal path, both in terms of rising primary bond issuance and the risk of more credit rating downgrades. In a flexible interest rate allocation fund, against the current investment backdrop, our objective is to allocate to the least inferior of the two. Considering the above, we consider nominal bonds to be the least inferior option.
- Yield curve dynamics favour nominal bonds more, especially when it comes to technical drivers such as the so-called yield curve roll-down effect.
- The low level of bond yields in many developed markets is still contributing to a spillover into higher-yielding developing countries.
- A Moody’s rating downgrade to sub-investment grade will force the exit of index tracking managers. This will impact nominal bonds for two main reasons. Firstly, nominal bonds will be excluded from the Citi Group World Global Bond Index (WGBI). Secondly, the inflation-linked bond holding in foreign hands is small. That said, a potential nominal yield spike in response to large-scale selling due to a downgrade may be offset by unconstrained foreign and local investors opting to take up bonds at the cheaper levels
Most importantly, our current investment strategy is already reflecting the significantly reduced importance of the inflation-linked bond asset class. Arguing loosely that any fund should have inflation protection at all times, simply based on a history of inflation volatility, may carry a high opportunity cost.
We need a much better fundamental understanding of underlying inflation developments (and the changing dynamics of ice cream tubs). For this reason, we are conducting in-depth inflation-related research to enable the best informed future investment decisions.
Who knows, the inflation monster may very well still be lurking around the corner? Or perhaps we are already back to the virtually zero-inflation environment that characterised the world economy for centuries prior to the First World War. However, let’s not jump to conclusions without delving deeper first.
Get the PDF version of Mad world - The ongoing “Japanification” of the global bond market - and my ice cream tub.