There is a general consensus that a critical theme for fixed income investors is whether the world is headed for reflation or deflation, but few are willing to make a call as to which way it’s likely to go.
Despite the uncertainty, Ardea Investment Management investment manager Ben Alexander warned the break-even trade is not the right path.
Alexander also said inflation-linked bonds are just one tool for betting on reflation/deflation.
“The opportunity to trade this theme is more a relative-value one, and the opportunity should be viewed though pricing derivatives as well,” he said.
While there are short-, medium- and long-term themes around inflation, Alexander said the primary focus in Australia is wages, which suffered from ‘low-flation’ when mining investment fell off a cliff after 2007. Given that Australia’s inflation story is not an exciting one, he believes the best local investors can do is be patient, and wait for a boost from the US.
Given the current environment presents relative-value opportunities, Alexander’s number one way to play the reflation angle is a curve trade – what he calls the “break-even steepener”. He prefers short duration to long break-even trades.
“It’s still possible to put together a fixed-interest portfolio that does benefit from this inflationary scenario, and these are the things you put into it, without taking on more risk,” he said.
Alexander made the comments at the 2017 Investment Magazine Fixed Income, Cash and Currency Forum, in Healesville, Victoria, in July. The panel topic was: Betting on Reflation or Deflation: Managing the risk.
Suncorp executive manager, investment strategy and advice, Gwion Moore, told the forum technological disruptions are re-making the inflationary landscape. As examples, he pointed to an evolution in the way technology is manufactured, and how e-commerce is interrupting traditional business models.
These trends might lead to a massive drop in prices for goods and services, by as much as 90 per cent in some cases, Moore said. Given the nature of these deflationary forces, he warns it is vital to adopt a flexible approach.
“Within fixed-income markets, exposure to these different areas means you can balance short-term cyclical pressures versus long-term drivers that are moving in the opposite direction,” he explained.
Franklin Templeton Investments managing director, fixed income, Chris Siniakov, said he was suspicious of arguments based on the quantity theory of money, an economic theory that states the general price of goods and services is directly proportional to the amount of money in circulation. Siniakov said that orthodoxy was based on a conceptual misunderstanding.
While quantitative easing lowered credit spreads, and raised equity-market valuations, he remains suspicious of the argument that it lowered nominal interest rates. Despite his reluctance to make an outright directional bet right now, Siniakov thinks the most likely outcome is a continuing decline, in average, of long-term nominal rates.
