Helping European investors navigate inflation fears

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:

1. Should I consider adjusting my portfolio allocations based on higher inflation risk?
2. What are the most attractive fixed income sectors in an inflationary environment?
3. Where are there still pockets of value and opportunity in global financial markets?

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.

An uncertain 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).

Prepare for divergence

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:

• Yield-curve sensitivity: The concept of empirical duration analyses historical asset class sensitivity to changes in local interest rates. With US and European rate hikes set to occur on different timetables and at different paces, it is important to consider how European assets may react to changes in US rates, assuming European rates remain unchanged.
• Hedging costs: With European interest rates lagging those in the US, the costs of hedging US dollar exposure may increase, making USD-denominated bonds less attractive on a EUR-hedged basis. Hedging costs are therefore another key consideration in fixed income allocation decisions — one that we’ll explore in a subsequent blog post.

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).

Figure 1

Focus on flexibility

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:

• Managing overall portfolio duration by allocating to sectors that have historically exhibited low sensitivity to rising interest rates (such as high-yield bonds) and/or allocating to shorter-dated bonds.
• Employing a flexible, return-seeking multi-sector credit strategy, providing opportunities to rotate among sectors in seeking to exploit relatively attractive valuations.
• Investing in floating-rate bank loans (whose yields reset higher as interest rates increase) and other sectors that may offer some structural protection against rising yields.
• Identifying and investing in sectors that have historically exhibited positive convexity (whereby a bond’s duration tends to decrease as yields increase), such as convertible bonds.
• Pursuing additional credit spread opportunities, such as high-yield bonds and emerging markets debt, in an effort to mitigate the portfolio impact of rising interest rates.

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.

Related content

• Euro area: challenging long-held assumptions (February 2022)
• Fixed income: Turn to nontraditional sectors for greater return potential in 2022 (February 2022)
• A credit strategy designed for all seasons (December 2021)
• Playing inflation defense with fixed income in 2022 (December 2021)