Donald Trump’s surprise victory in the US presidential elections has already set the stage for a rise in US inflation, and triggered some sharp reactions in the bond markets. Specialists in inflation-linked assets are naturally following this trend closely, and Jérôme Broustra, head of global rates, fixed income at AXA Investment Managers (AXA IM), spoke to Asia Asset Management in an interview about the prospects for inflation-linked bonds under a Trump presidency.
Mr. Broustra sees most of the measures that have been proposed in Trump’s programme as “extremely supportive for inflation, specifically in the US”, although he adds: “We don’t know how many of the promises will be implemented.” Fiscal policy measures such as tax cuts will be quite supportive for final demand, and therefore will translate into higher inflation. Protectionism and immigration controls will tighten the labour market and increase the price of imports. If you add, on top of that, tariffs – which is the most inflationary short-term measure, it will be extremely positive for inflation, as it will put a barrier to import prices.”
These expectations, Mr. Broustra adds, do need to be qualified in a couple of ways: “First, investors have to be selective in sectors. For instance, if you look at the Obamacare amendments – those will be positive for inflation in the healthcare sector. This is quite an important component of the CPI Index, but we cannot rule out the fact that [Trump] will at some point limit his ambitions. Secondly, we believe that he will not be able to implement all the promises he has made, and we’re supposed to take into account some imbalance due to potential disappointing growth in the case of too much negative sentiment surrounding the Trump election.”
Nonetheless, AXA IM’s view is that core inflation in the US will remain above the 2% level in the course of 1Q2017, despite expecting some volatility. In the current circumstances, the firm expects inflation-linked bonds to be the best instrument to deal with in this inflationary scenario.
Mr. Broustra explains the dynamics of inflation-linked bond performance, in the context of a normalisation of the financial markets away from the post-crisis paradigm of low-to-zero interest rates and closely correlated equity and bond markets. “What we have had since September is the beginning of normalisation in terms of yields,” he avers. “Yields are starting to rise. The equity market is relatively solid. This is the proof that we have ended the new paradigm: this is, to us, a turning point. We are coming to an end of the long secure trend of rallying in the bond markets.”
As for bond performance, Mr. Broustra sees a correlation between higher yields and inflation. He opines: “Usually when inflation comes up, the variable component of the inflation-linked bond is capturing this positive momentum by offsetting this rise in yields. There cannot be a rise in yields without inflation. If you have a bond that is sensitive to inflation variation, you get the carry of this acceleration in inflation, without suffering from rising yields, or suffering less.”
Near-term policy should underpin a gradual normalisation of the bond markets, with an extremely prudent US Federal Reserve, which experts believe will prefer remaining behind the curve in terms of central bank action, in order not to interrupt the modest growth that is anticipated.
“We believe that the Fed will prefer adding some over-inflation instead of killing the growth, even though rising yields are the enemy of the bond markets. It also makes sense to be underweight bonds versus equities,” comments Mr. Broustra. Because of this, there is still room for fixed income markets to perform positively.”
Expecting a steepening in the yield curve, AXA IM favours short-dated bonds as opposed to long-dated bonds, and Mr. Broustra adds: “Where they break-even, the difference between nominal and real yields, remains below core inflation.” The firm also sees a far more consistent story in the US than Europe, as the UK remains vulnerable to the unravelling of the Brexit story, and inflation in the eurozone is likely to be “less constructive” compared to the US. This is mainly due to political uncertainty and volatility in France, Italy and other pockets.
With regards to prospects in the new year, Mr. Broustra concludes: “The profitability of banks will increase in 2017, because with steeper curves, they can transform the money they use and put it to work by lending money to customers. The steepening of the curve is positive for banks, and this is likely going to further fuel growth in GDP.”