Jonathan Marriott – Chief Investment Officer
We have seen a dramatic rise in inflation this year and central banks are responding by raising interest rates. Bond markets have been hit hard as they move to price in higher rates. Some investors will turn to inflation-linked bonds to benefit from rising inflation. Banks who tend to take deposits at low interest rates to lend at a higher rate find it easier to make money with higher interest rates, so you could assume it is a good time to buy bank stocks. These are investments made on simple assumptions that overlook other factors that influence market pricing. This year both assumptions could have led you astray.
Calculating inflation-linked bonds returns
The problem with inflation-linked bonds is that there are two components to their returns. There is the inflation component but also an interest rate component. Taking the UK as an example, the Retail Price Index was up 9% year on year in March[1], and prices will rise further in April following the increase of the energy price cap. The 10-year inflation rate predicted by the difference between conventional and index linked bonds rose from 3.94% to 4.36%. Both factors should benefit from the performance of index-linked gilts and, as an example, the iShares index-linked tracker is down 11.8% this year. Hit even harder than the tracker on conventional gilts, which are down 9.9%.
The problem is that the index-linked market is very long dated, and the index has an average maturity of 21 years vs the conventional market which has an average maturity of 15 years. [2] The difference is even more marked when we look at duration, which is a measure of interest rate sensitivity. The index-linked tracker has a duration of 20 years, meaning that if the yield of all bonds moves up just 0.1%, the price falls 2.0%, all other things being equal.
The conventional gilt tracker has just an 11-year duration, so just over half the sensitivity to interest rate moves.[3] This year, the sell-off in bond markets has dominated over the rise in inflation expectations. This demonstrates that a simple assumption that index-linked bonds protect when inflation rises can be misleading. Looking at what is already priced, the direction of interest rates and the sensitivity of individual bonds may be a better approach. For a UK taxpayer investing in individual gilts, the tax treatment may have a bearing on return expectations.
Default rates rises and bank profitability
When looking at banks, I will look at the US market where Treasury yields have risen dramatically, and the banks have limited exposure to Ukraine and Russia. The Federal Reserve has started to raise rates last month and is expected to continue to do so through this year into next. In theory, this should be a good environment for rising bank profitability.
Typically, we expect to see rising interest rates against a strong economic background when inflation is largely driven by demand. On this occasion, while demand is strong, supply constraints and the war in Ukraine have been a significant factor. The risk now is that in order to contain inflation, Central Banks raise rates so fast and to such an extent that they risk triggering a recession. This could see default rates rise, thus reducing the benefit from higher rates. The iShares S&P US Banks tracker has dropped 5% so far this year[4] reflecting this risk and perhaps the risks to their wider activities, such as investment banking. So again, looking at a single factor when investing can lead investors astray.
Holistic analysis
When looking at investment in any field, it is important to assess all the factors that can influence prices and try to avoid simple assumptions. Any investment is a balance of risk and return which requires careful judgement. Looking carefully at what is already in the price and where a possible deviation from that may occur is key. It is possible that if central banks act too aggressively, driving down demand as the supply side recovers, inflation falls back sharply as the global economy slows. In that event, we may see pressures on the bond market abate as rate rise expectations moderate. In such a scenario, conventional gilts would outperform.
A final thought
Every morning I hear the FTSE 100 Index reported on Radio 4 and some people still see it as an indication of UK prosperity. This may have been the case many years ago, but it is now largely made up of international companies that are listed in the UK. Oils and mining stocks make up a significant proportion of the index and there is hardly any representation for technology. In the first quarter of the year, the FTSE 100 was up 1.7% (in price terms) outperforming other global indexes which fell.[5] Shell alone made up most of this return. About three quarters of company earnings within the index come from overseas. The FTSE 350 Domestic Index, which includes companies with more domestic sales, fell 9.3% in the first quarter.[6] So, if you are concerned about the domestic UK economy or looking to benefit from an expansion, then the FTSE 100 Index may not be the best place to look.
[1] Source: Bloomberg
[2] Source: as at 19th April, iShares
[3] Source: as at 19th April, iShares
[4] Source: Bloomberg
[5] Source: Bloomberg
[6] Source: FTSE Russell
