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After years of near deflation across much of Europe, the region is now witnessing persistent price increases. Second-order effects of recent geopolitical developments, particularly the ongoing war in Ukraine, are intensifying the current inflationary environment. This apparent shift to a higher inflation regime, with the resulting expectation of tighter monetary policy and rising interest rates, presents a material challenge for European fixed income investors, raising questions such as:
How best to answer these questions depends on the specific circumstances of each investor, but over the coming months, we aim to share some pointers to help European investors think through the implications of higher inflation for their fixed income portfolios. As a first step, let’s take a closer look at the challenges presented by today’s uncertain market backdrop.
Following the reopening of the global economy, markets have shifted their focus to how central banks plan to unwind monetary stimulus and respond to the new, more inflationary environment, with potential implications varying by asset class and region.
Fear of potentially derailing the economic recovery initially led global central banks to tolerate price increases well above their normal inflation targets, but faced with stubbornly high inflation readings, most have now changed course (albeit at different speeds). The tragic events in Ukraine have added another layer of uncertainty to the macroeconomic picture, but they have not (yet) altered our belief that investors should prepare for the end of accommodative monetary conditions and consider positioning their portfolio allocations accordingly.
For financial markets, one of the most striking implications of the Russia/Ukraine conflict has been the sharp upward moves in energy and other commodity prices recently. (Both countries are major global commodity exporters.) If anything, this has reinforced our outlook for higher short- and medium-term inflation and the resulting need for tighter monetary policy (including higher interest rates).
As world central banks react to inflationary pressures at different speeds, we see an increased likelihood of a divergence in interest-rate cycles. This may have ramifications for European assets and asset owners who seek to hedge their global portfolio exposures:
Ultimately, a myriad of factors and potential scenarios could impact fixed income returns over the short and medium term as we progress throughout 2022 (Figure 1).
In summary, the current global environment is characterised by widespread, rapid reflation and diverging central bank monetary policy responses, but also by heightened uncertainty around geopolitical risks. Despite the challenges posed by this environment, we believe market opportunities remain plentiful and the role of a diversified portfolio paramount for fixed income investors.
In practice, European investors have a variety of tools at their disposal to help navigate this global landscape, including mechanisms to defend against — and potentially take advantage of — rising inflation and interest rates. For example:
Given the number of “known unknowns” these days and the broad range of potential outcomes going forward, we encourage fixed income investors to be as flexible as possible and to consider adjusting their base cases (and their portfolio allocations) as new information arises.