Off the charts: Inflating the Debt, TIPS, Office Real Estate

As markets start to increasingly price in a scenario of returning to economic normalcy, a lot of investors are looking at what all the unprecedented stimulus measures mean in the long run for indebtedness and inflation. Ballooning of government deficits coupled with central banks’ asset purchases make all of us question the future of macroeconomic policy in the developed world. Whereas some look for clear-cut answers on what these mean, we believe the interplay between central bank money supply, increasing government deficits, and other secular forces is a complex one.

Fig. 1: Debt ratios rise with inflation uncertainty risk

Modeled debt as a share of GDP, with a rise in inflation to 7%

Source: UBS

Note: The chart assumes inflation rises from 2% to 7%, adding a 1.5% inflation uncertainty risk premium. The government runs a 1% GDP primary deficit. The debt has the same maturity profile as the national debt of France. There is a minimal reduction in debt-to-GDP immediately after the inflation shock, as most bonds still incur the old interest rate. Within five years, half the bond market incurs the inflation uncertainty risk premium.

As our chief economist Paul Donovan says in his piece Can debt be inflated away?, “One of the myths that exist about inflation is that governments can easily inflate away their debt levels.” He points to two reasons. First is that a lot of government spending is already tied to inflation, ranging from Social Security payments to the goods and services that they purchase. Second, bond investors would be unwilling to finance the debt if inflation was rampant. In the current paradigm, the central banks would step in as marginal buyers to keep the rates low, but that would not come without its costs either.

Fig. 2: 5–7 year TIPS meaningfully underperformed in March, and are now cheap relative to nominal Treasuries

Source: Bloomberg, UBS, as of 4 May 2020

Yet, we do not think that runaway inflation is around the corner. Japan is a case study showing that increasing debt and very active central bank action does not always lead to hyperinflation—or, in the case of Japan, any inflation. There are other large forces that affect it such as demographics or productivity. Therefore, at the current moment, hyperinflation fears are overblown. At the same time, most central banks would be open to inflation running a bit higher than normal. That’s where Treasury Inflation-Protected Securities' (TIPS’) importance in portfolios comes in. In a world where nominal rates are close to zero, TIPS can offer a way out for investors who would still like to get paid for the inflation risk they are taking. We think especially the 5–7 year sector provides great opportunities. Please see Leslie Falconio's report, TIPS for the long term, and the US fixed income team's latest Fixed Income Strategist report, for more details.

Fig. 3: After COVID-19, how many workers will continue to work from home?

Survey of 317 CFOs and finance leaders

Source: Gartner Inc, UBS

Also in the Fixed Income Strategist report, we provide a comprehensive snapshot of fixed income markets and where we think the opportunities are. One of the most intriguing parts of the fixed income is commercial mortgage-backed securities (CMBS). Not only are there many questions about the sudden stop in the economy, and therefore how missed rent payments will affect the mortgage market, but also many longer-dated ones about whether COVID-19 will lead to less demand for office space as working from home becomes more prevalent. In What happens next?, our US real estate analyst Jon Woloshin digs deep into what the future holds for office real estate markets.

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