Inflation takes flight – but what goes up must come down

One thing is indisputable, it is the main theme of the first half of the year; a period marked by weak and volatile financial market performance.

Consensus suggests that this weakness and volatility can be largely attributed to inflation, and bonds are a traditional victim of such an environment and therefore not a surprise – but equities, bitcoin, and recently real estate have all suffered despite traditionally serving as an inflationary hedge.

Surprisingly, some market measures of inflation, such as the 10-year breakeven rate, is almost unchanged over the first half of the year. Treasury yields are the sum of two components: breakeven rates, the measure of inflation and real rates, the return after inflation.

The story of markets in the first half is about more than surprisingly strong inflation; the repricing of real rates is a disruptive force to be considered and along with it the tighter financial conditions and declining leading indicators that resulted.

Bond market pricing presented a challenge to start the year; unraveling as the Fed walks back its recently adopted higher tolerance for above-target inflation, alongside a rise in real rates.

The 200bps rise in 10-year real yields, as an example, is larger than the one experienced from 2016 to 2018 as the Fed embarked on the last rate hike cycle. It is also more than that of the 2013 Taper Tantrum. Certainly, much more dramatic than the change in breakeven rates.

With the Fed expected to continue aggressively hiking into a slowdown, the risk of a disruptive end is growing.

The Fed remains convinced of a soft landing for the economy, but inflation may realistically only normalise in a downturn, with higher unemployment. History offers no comfort from periods where unemployment rises even by small margins.

Few markets if any are currently priced for that risk, and that includes the GCC bond markets.

Despite all the headwinds, spreads here are nearly as tight as they have ever been, as the region benefitted from its natural buffer to high inflation through its exposure to oil prices.

The improvement in sovereign fiscal balances has improved credit profiles, and this has been most notable in the high yield universe. As a result, the average yield in that high yield space remains a far cry from 2020 levels, or even 2018 selloff lows.

Investment grade yields on the other hand have danced to a different tune, reaching 2018 and 2020 levels: presenting a compelling opportunity.

In fact, there are now nearly twice as many investment-grade bonds trading below 90 cents than at the 2020 trough, and 12 months forward returns from such yield levels have consistently resulted in double digit total returns.

As always, the outlook is not without its risks. Despite yields being as high as they are, spreads of these investment grade bonds are still low. It is reasonable to expect, as a result, for them to widen from their current levels, dampening potential returns.

However, the more meaningful risk resides in a continued rise in rates, likely alongside continued upside surprises in inflation – this scenario however might be challenged by an approaching recession, limiting the time rates stay elevated, as its likelihood increases under such a scenario.

All things considered, the opportunity presented in regional investment-grade bonds stands out in the asymmetry between the upside and downside at present, particularly in comparison to other markets.

The broader universe of risk assets, such as equities or high yield, have further to decline in a downturn, and historically bottom only slightly before economic troughs, or at a pivot in Fed policy towards easy; neither of which are currently in place.

To conclude with food for thought; is the distinction of inflation as either transitory or permanent a useful one? Isn’t anything transitory or permanent depending on a time frame? After all, what goes up…

Sharif Eid, Portfolio Manager, Global Sukuk and MENA Fixed Income, Franklin Templeton.