The release of the January euro area HICP (Harmonised Indices of Consumer Prices) inflation surprised sharply to the upside and spurred talk of inflation risk. With vaccines rolling out, central banks continuing to support financial markets, and several governments providing fiscal stimulus, is higher inflation a risk?
Assessing the German inflation data specifically, we find that mostly the surprise is attributable to one-off factors such as the reversal of the VAT (value-added tax) reduction and changes in weights. While we believe the COVID-19 vaccines are leading the economy on a path to recovery, we also believe it will be uneven and take time. We expect GDP in Europe to normalize to pre-pandemic levels in 2022, not this year. With such a slow pace of re-normalization, we expect that inflation will remain low and increase only gradually over the next 12 to 18 months.
With such a slow climb to pre-pandemic economic growth, some investors may be quick to dismiss the potential value of inflation hedging in Europe. However, the market is already factoring in a slow re-normalization, with expected inflation rates in 2022 below 1%, and not much higher for the remainder of this decade. Such low inflation expectations may provide an opportunity to invest in attractively valued inflation hedges given the current global fiscal accommodation and the potential for inflation surprises beyond the immediate future.
What’s the risk to euro area inflation in the medium term?
We believe fiscal policy will be more important than monetary policy for the euro area inflation outlook going forward. Europe’s economy is still far from running at full capacity, and accommodative European Central Bank (ECB) policy is necessary to keep sovereign financing costs contained but is achieving little else. In our view, the most effective way to stabilize the economy is through government spending, and the multiplier is even greater when economies are at the zero lower bound. We want to call out two positive euro area fiscal policy developments:
- EU leaders have reached an agreement on the EU’s recovery fund after the COVID-19 pandemic began and “paused” world economic activities. Though the headline number of the EU package looks much smaller than the total expected U.S. recovery and relief plans, there is no doubt that this is a significant step in the right direction. It’s a strong signal that the European project is alive and that it remains in the interest of most countries to cooperate in the face of adversity. While the size of the stimulus is only about 2% of euro area GDP per year, it’s very different from the austerity measures that were implemented after the sovereign crisis.
- Reaching an agreement among the 27 member states, albeit far from easy, gives EU countries an opportunity to transform the European economy, making it greener, smarter, and more resilient to future shocks – leaders generally agree the risks of failing to do so are huge. In our view the peripheral countries will likely play a major role in this, not only because they are the most represented region in fund distribution, but also because they are the countries with the greatest potential for real progress to be made. The good news is the return of Mario Draghi, now as Italy’s prime minister – this has changed the Italian political landscape dramatically and brought confidence to the market. It’s hard to overstate the stakes here. Draghi’s success or failure in deploying the recovery fund and embarking on key reforms will be critical not only for Italy’s future, but also for the European project. The former ECB president is probably the best candidate for this task given his deep understanding of his country and his reputation as the man who saved the euro during the sovereign crisis. This is another tailwind that might help to lift growth and inflation in the euro area.
Why invest in inflation-hedging assets now?
Investors should not disregard the threat of inflation simply because it has stayed low for the past several years. Moreover, the market has not reached a consensus that inflation will re-emerge, so the return profile is asymmetric given the market hasn’t priced in sufficient inflation risk premium.
Using the euro HICP market as an example, the five-year, five-year-forward (5y5y) implied breakeven inflation rate based on the inflation swap market is currently around 1.4%, which means the market predicts that average inflation between 2026 and 2031 will be 60 basis points below the ECB’s target. Even without investors taking views on the direction of future inflation, the likelihood of higher price volatility introduced by aggressive central bank quantitative easing itself should increase the convexity value of inflation-linked bonds (ILBs) because of the embedded option.
Another risk worth considering is the scarcity of linker supply. The issuance in ILBs is much smaller than in nominal sovereign bonds, and governments might reduce the linker issuance further if they start to worry about the source of inflation. The essence of risk is that once inflation re-emerges, it tends to be much harder to hedge.
Finally, ILBs have a unique set of return, risk, and correlation characteristics that differ from conventional bonds. Portfolios may benefit from the increased diversification resulting from a mix of nominal and inflation-linked bonds, thus improving their return/risk potential.
For PIMCO’s insights on U.S. inflation, please read this recent blog post: “Fiscal Spending Could Cause a U.S. Growth Spike – Compounding Investors’ Concerns on Inflation.”
Lorenzo Pagani is a managing director and portfolio manager focused on European government bonds. Yi Qiao is a senior vice president and portfolio manager focused on interest rate derivatives and inflation-linked strategies.