A focus on inflation-linked bonds
The COVID-19 pandemic profoundly reshaped the global economy, triggering a long-unseen surge in inflation through disrupted supply chains and unprecedented fiscal and monetary policy interventions. Despite inflation peaking at 10.6% in Europe and 9.1% in the US in 2022, market expectations of inflation over the medium- and long-term have remained stable since the start of COVID. This suggests that markets were confident inflation would return to normal levels quickly.
While inflation is normalising at present, the overall process has been hindered by the persistent inflation in services, a relatively strong labour market and second-round effects, such as insurance costs. The graph below illustrates how the inflation normalisation to the 2% target in both Europe and the US has stalled, raising questions about the appropriate level of policy rates needed to bring inflation back to target.
Euro area and United States CPI YoY%
Source: DPAM, Bloomberg, Eurostat and BLS, 2024
Currently, inflation is at 2.5% in Europe and 3.0% in the US. Monetary policy transmission is working as higher policy rates continue to weigh on demand in advanced economies. Labour market conditions have also started to ease. As expected, the last leg of inflation normalisation has proved to be more complex, as shown by the higher-than-expected inflation in early 2024—particularly in the US. However, given the trends in shelter, wages, the business cycle and some industry-specific dynamics, we are confident that inflation normalisation is well underway.
Shelter remains a very slow-moving component of inflation, accounting for around 36% of the US CPI basket—a major contributor to US inflation. However, based on measures such as Zillow Observed Rent Index (ZORI), Apartment List National Rent Index and CoreLogic’s apartment rent listings, we expect shelter inflation to continue to slow down in 2024, eventually returning to pre-COVID levels.
On the economic side, delinquency rates continue to rise in the US. The latest GDP numbers were lower than expected, pointing to a weaker US consumer. A weaker consumer implies reduced spending, which may lead to a more benign inflation rate. We do not expect the trend to shift in the coming months.
The effects of tighter monetary policy are gradually being passed on to the labour market. The number of vacancies and resignations has dropped to pre-pandemic levels. In the US, the unemployment rate has increased to around 4.1% from a low of 3.4%. As the labour market stablises, wage increases are likely to moderate to levels more aligned with inflation targets.
On this basis, we see three possible scenarios for inflation going forward.
Looking ahead, three key factors suggest that inflation may stay above pre-COVID levels for some time—supporting our base case.
The first factor is deglobalisation. Developed countries, particularly the US, are pushing for the reshoring of manufacturing and services to reduce future risks and lessen economic dependencies with other nations. This shift means countries must handle the entire production of goods and services themselves. They will have to bear the increased costs of this independence as they decouple their supply chains from for example Russia (cheap energy) and China (affordable goods).
The second factor is the increase in geopolitical risk, primarily affecting commodity prices, including oil. Given the ongoing or potentially increasing geopolitical risks, inflation-linked bonds are likely to retain their value as a safeguard against the resultant volatility in commodity prices.
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The chart below clearly shows the link between oil prices (green line) and the price of inflation for a US inflation-linked bond maturing in 5 years (blue line).
Oil and US inflation expectations
Source: Bloomberg, DPAM, 2024
A third factor is climate transition, a key issue for many countries committed to net zero by 2050. Beyond the energy debate and the shift from reliance on cheap Russian gas, we also face the impact of climate change and stringent environmental policies. Extreme weather events also disrupt agricultural production and supply chains, costing around USD 250 billion in 2023 alone (Munich Re, 2024 ). These environmental disasters will continue to lead to volatile food and energy prices. Additionally, the move towards greener energy sources in heavy industries is expected to decrease productivity and increase product prices.
These drivers altogether will help to get us out of the structurally low inflation from before COVID. Nonetheless, many of the deflationary drivers from the past decade still survive, including demographic effects, lack-lustre productivity, etc. Adding it all together, our base case scenario is for inflation to be structurally higher, more cyclical, but well contained.
The market prices benign inflation expectations over the medium and long term. A normalisation of actual inflation prints towards the end of 2024 could reduce these inflation expectations. However, we believe deglobalisation, geopolitical risk and the effects of the climate transition will keep inflation structurally higher than pre-COVID levels for the foreseeable future. We would add inflation-linked bonds as soon as the market prices lower inflation expectation as a cheap entry point to safeguard portfolios against our medium-term inflation expectations which are now structurally higher than pre-Covid.
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