Peter Marsland: Welcome to the Aberdeen Standard Investments Fixed Income Team Talk, I’m your host Peter Marsland. I’m a Fixed Income Investment Specialist and today we'll be discussing the outlook for inflation and what this means for investors.

Today I’m joined by Adam Skerry, Head of Inflation within the Rates team, good afternoon Adam

Adam Skerry: Good afternoon

Peter: Joining myself and Adam is Tom Walker, Investment Director, focused upon Inflation-Linked portfolios - hi Tom

Tom Walker: Afternoon

Peter: And last but by no means least, I’m joined by Jamie Irvine an Investment Manager within the Sterling Investment Grade team, focused upon corporate bonds - hi Jamie

Jamie Irvine: Good afternoon

Peter: So as has become the norm with these Team Talks, we're first going to go a little bit off-piece and not focus on the investment world - we're going to focus on something quite topical in the sporting world and that's the European Championships.

Now we've just come into the end of the first-round games, so each team has been in action at least once and I’m going to ask our guests today for their predicted winner for the tournament, so we can really check to see how good they are at forecasting.

So, I’ll kick this off and I saw this team play last night and they have thoroughly convincing performance over Germany - so they are one of the favourites - but I think that France will go on and add the European Championship trophy to the World Cup that they won a few years ago, so my pick is France. Let's throw this open to Adam, who do you think will lift the trophy?

Adam: I mean it would have been nice over the last year or so if we could have done a bit of due diligence and travel around Southern Europe and you know see how good these teams are, but unfortunately that's not been possible. But you know for me I’m going to have to stay pretty close to home and say England. But I think in the interest of, sort of, team harmony, I’m just hoping that this Friday is an honourable score draw between England and Scotland and yeah, there's no friction between the Edinburgh and London offices afterwards.

Peter: A very strong patriotic response there, maybe a bit more ‘heart overhead’ but let's hope you're correct. Tom who do you fancy?

Tom: Yeah, nice I have to admit I’ve not thought long and hard about this, football's not a sport I follow that closely, but I feel like, you know, all my compatriots singing ‘football’s coming home’, I mean they must all be right, so I’m going to go with Adam as well and go with England to win it this time. But yeah, I think it'd be interesting to see the England v Scotland battle on Friday.

Peter: I think ‘battle’ could be the appropriate description. Finally, Jamie, who do you think will go on and succeed?

Jamie: Well, I think Adam and Tom are both been very diplomatic and saying that they're hoping for a draw between England and Scotland tomorrow. I for one will be shouting loudly for Scotland to score as many goals as possible against England, but I fear that may end up coming back to bite me. And just as a Scotland supporter, we're just happy to be here, to be in the tournament for the first time in a couple of decades. So, I think for the overall winner I quite like the look of Belgium, I think they've got quite a few superstars in there. I can't bring myself to say that I think England will win the whole thing although, I think they might give it a good job.

Peter: Good choice, I think Belgium do look very good on paper and let's hope they can, well for their sake, translate that into form on the pitch.

Okay, now let's turn back to investment matters and inflation is becoming, you know, a very hot topic at the moment. Markets predicting growing inflationary pressure as we come out of the sort of pandemic lockdowns, and activity starts to normalise, and people start spending hard as well. Recent CPI print - so consumer price inflation prints - have been above the target set by central banks such as the Bank of England and the US Fed.

So, central banks find themselves in a bit of a dilemma on how to respond to this inflationary pressure - do they act now or do they act later. So, the first question we're going to tackle today is - one I’m going to pose to Adam - which is, will the inflationary environment prove to be transitory or are we about to embrace a higher inflation environment that may last for years to come - over to you Adam.

Adam: Yeah, I think it's a question that's on everyone's kind of lips at the moment and you know, if you listen to the central banks, they're certainly in the transitory camp. So they're very happy to sit on their hands for now, and you know let these numbers as you've already pointed out, wash through in their perspective.

So, you know the last CPI print in the US had a five handle on it, we had some UK numbers out today which beat expectations again particularly in terms of core CPIs. So, there is definitely a kind of ground swell of inflation you know pointing upwards. The base effects and the kind of rolling 12-month effect of the Covid lockdowns and shutdowns that we saw globally, are you know largely to play here in terms of where the inflation numbers are printing. So for example, you know, used car prices - the reopening sectors such as hotels, airfares, package holidays - these kind of things are predominantly what's driving these headline numbers higher.

I mean what's of particular interest to us when we're looking at this in more of a kind of strategic sense as opposed to what's going to happen in the next one to three months, are the underlying structural impacts of Covid and the subsequent reaction functions that we've seen - both from central banks and from governments. And that leads us to believe that you know, over the last 30-35 years or so we've been in this, what's called the great moderation, where we've been an environment of low inflation, relatively low growth, relatively low unemployment, low interest rates. The Covid shock – or the Covid kind of shock to the economy – has kind of blown that open. So now we're saying that the tail risks are kind of opened up, so the possibility of getting higher inflation for a longer period of time is now significantly higher than it was prior to the 2020 Covid pandemic.

Now underlying that, there are several factors and it's you know up to us to kind of judge how much weight we put behind each of these, but we can't deny the fact that there are unprecedented kind of fiscal deficits being run here. We've got unprecedented scale of QE and central bank stimulus being put to work, which as I say outside of wartime, we just, we never really see these kinds of numbers. So even compared to the 2008 global financial crisis, these numbers are you know off the charts, so you know, we can't get away from the fact that, that has happened. And when we look at the central banks, and we look at the governments, there's not any sense at the moment that they're prepared to take that away prematurely. So that degree of stimulus is still going to be there for the foreseeable future, so that gives us the kind of you know backdrop to that inflationary environment really being kind of driven by the authorities that are there.

Now the sort of second round effects of that degree of stimulus are being felt both in terms of personal balance sheets and the outlook for the corporate sector. So for example the degree of excess savings being built up by individuals - predominantly in the US - but also across other areas of the globe, again are at the very high end of historical norms.

So for example in the US there's around about £2.2 trillion estimated in terms of excess savings that's around 10% of GDP. Now even if you apply a relatively small multiplier to that so i.e. how much of that is going to be recycled into the economy, it still gives a huge kind of upward impulse to the kind of demand side of the economy. And that's true across you know, when we look at China, when we look across Europe, there are these excess savings sat there on the side-lines. So depending on how quickly you think that re-enters the economy, that is a factor that one has to kind of consider - at least for the next couple of years. This isn't you know likely to be splurged in one hit in the next two or three months but it is likely to be you know fed into the economy over a relatively protracted period.

On the other side of that, we have the employment story. So, we've probably all seen the unemployment numbers more recently starting to come down quite dramatically and that's really hit pinch points in the US. So we are starting to see wage pressures really starting to accelerate in the US. Now I think when the economies started to reopen there was always going to be a degree of friction, between those that were unemployed and those that were looking for work and the availability of jobs out there. But what we're starting to see now - not just in survey data but actually in hard data - is that companies are finding it hard to find employees.

So for example if McDonald’s are offering $500 to get an employee to sign up to them, Walmart are talking about lifting their minimum wage well above the kind of $15 that's been moved by the Biden administration. So there are these kind of you know factors that are starting to give us the impression that wages could actually be on a relatively persistent upward trend. And that's going to be crucial, because if we think that inflation is going to be persistent it needs to be underpinned by wages. It's not just governments kind of throwing money at this, it is also structurally an environment where firms feel comfortable to actually pay their employees more, to take more employees on and then you know we start to see that circularity of the money, that once these people get money in their pockets that resurfaces in the real economy. So as I say, the employment picture is key.

On a slightly more long-term theme, there's too many elements to what we've been looking at. And this is true for the kind of pre-pandemic period as well, these are trends that we started to look at - so specifically we're looking at demographics. So as we know the working age population is shrinking, there are more dependents out there to pay for, so effectively that means that you've got an aging population globally but particularly in the developed economies, whereby these people are taking themselves out of the workforce - so i.e. they are unproductive in terms of economic output - but they still consume. So they're still demanding goods, they're still demanding services, so therefore they are running down their savings, running down their pensions to pay for these goods and services - so thereby giving a kind of another upward impulse to the inflation outlook.

And second of those kind of longer-term structural themes is the de-globalisation theme. Again this was kind of put in train before Covid, it was a theme that was being discussed and that's really been accelerated by the Covid crisis. So, companies now looking at shorter supply lines looking to, you know bring their supply lines closer to home - just to ensure that they've got that security that they can actually keep their companies afloat, they're not reliant on these very complex and very long global supply chains to keep things ticking over. So if that means that they have to pay slightly more for that security, we're starting to see evidence that that is actually the case, and that's exacerbated by the populist move in politics in terms of that kind of internalisation of economies and also the tariffs and the trade barriers that have been put in place subsequently. So thereby, you know, there's another kind of supply-driven impulse to inflation moving higher.

So you know, in summary there are a number of factors there that make us think that the transitory rhetoric may have to be kind of revised. I think it's relatively safe for the Fed to do that for now because they can point to these one-off kind of idiosyncratic factors - as I say such as used car prices such as you know these little one-offs due to the re-opening - but we do have some you know more substantiated evidence now that inflation is likely to print higher than it has done for a number of years prior to 2020 and the Covid crisis.

Peter: Well thanks Adam, it sounds like there are a number of moving parts to the, to the backdrop that could prove to be you know making inflation a very interesting story for the months and years to come. If we do move into this more protracted higher inflation environment, what's that going to do for government bonds - Tom maybe I'll pose that question to you.

Tom: Yeah certainly, I think Adam has laid out kind of exactly the sort of things that are very relevant when we're thinking about central bank reactions, as well as when we look at what is priced into bond markets and what the ultimate reaction could be - should we see inflation sustain at, you know somewhat elevated levels. I think the bit of the mixture between the transitory argument, and you know a gradual return to normality and a dropping off of inflation, is quite key. So I think you don't necessarily need to say that US inflation is going to sit at or around the 5% levels that we're seeing right now for bond markets to still necessarily, you know, anticipate some reaction from central banks to remove some of the kind of you know stimulative policy down the line.

So, if we look at Inflation-Linked Government Bonds. In the US - and a lot of kind of developed markets - what we're seeing is you know, quite significant pricing of inflation for the here and now. I think there's quite a broad consensus out there for this kind of transitory shock that we're seeing but it's that persistence of inflation that's not necessarily priced right now.

So if we look at long-dated US inflation, you know the market's almost priced, you know, for perfection I would say and in so far as the Fed's target is priced to be achieved broadly on a very long horizon but there's certainly no significant inflation risk premium in markets. So I think on the ‘inflation’ element of inflation linked bonds, there could be some upside from here if this transitory inflation shock does prove to be a little bit more persistent than the market currently anticipates.

That being said you know, the policy response from central banks is quite key here in how they respond if inflation were to print, you know at or above target over the next couple of years. You know, how readily do they start indicating a tightening of financial conditions by you know reducing, you know, excessive balance sheets, tightening interest rates but raising rates. These are all things that can, you know, undermine the duration element of the risk you take within bond markets.

So if we look at, you know, historic yields on a global scale, we are still very low despite pricing some of this inflation upside. Real yields remain in the US in particular at all-time lows across the curve, so I think the interesting thing will be if there is a need for central banks to start addressing inflation, if it's you know, troublingly high would be something that would allow real yields to adjust higher.

Now that being said I mean, I think one of the big consequences of you know, much of the last 10 years and especially since the Covid pandemic, you know, there's a lot of debt in the system and you know quite rightly governments have responded with you know, significant deficits. So this debt stock is ever increasing you know within the kind of developed world, so the sensitivity of economies to higher rates is something that you know, I think puts a lid on how high yields can actually rise, without starting to short-circuit if you like some of the more risk-facing markets that we have. And I think if you were to see significant stresses in risk markets you know there is a little bit of a feedback loop, where safe haven demand for government bonds returns. So I think there is a little bit of a circular argument and we need to maybe have a little bit of time to assess the nature of the inflation that we're seeing - is it inflation coming alongside very robust growth - and as Adam alluded to you know a labour force that, you know gets increased pricing power - the wage dynamic is kicking in you know, these are a lot of things that could arguably be quite supportive for risk assets, if the growth is there. But if ultimately firms are struggling you know, to kind of you know, remain profitable you know, in the face of rising inflation - if they can't pass on the prices, then it's things like this that could start to peter out so, these are definitely the conversations that we're all having on desk and I think it might lead quite nicely into hearing what Jamie has to say on the on the risk-facing side of things

Peter: Well thanks Tom let's, let's pose that question to Jamie now. So that's the angle from say government bonds but if we looked at something a bit further out on the risk spectrum - so looking at corporate bonds - what's the impact likely to be of a higher inflation environment for corporate bonds Jamie?

Jamie: Hi, thanks Peter and as Adam and Tom have already alluded to it's the kind of question on everyone's lips as to, as to what extent this inflationary pressure persists and that is really what will be dependent on the impact for corporate bonds, it's the policy response if this is inflationary pressure is persistent and whether or not there are any short-term shocks to real yields or what the path of interest rates and the pace of unwinding of central bank balance sheets will be going forward. Generally speaking, Corporate Bonds and Risk Assets more broadly will react negatively to volatility in underlying government bond yields, rather than the actual level of yields themselves. There's mixed evidence throughout history as to the correlation of nominal yields and credit spreads, but where there has been a yield shock or some volatility and particularly where there's been a spike in real yields - so nominal yields adjusted for inflation - in most instances that has resulted in weakness and credit spreads. But right now the credit markets don't appear too concerned that the inflation prints that we're seeing are going to be anything more than transitory, the spread of the spread of the Sterling Corporates Index - spread being the yield pick-up versus underlying government bonds - it's currently at 107 basis points, which is a fairly tight level relative to recent history and you now have at least 8% of bonds in the index trading at the same or tighter spread level than they were prior to the pandemic. And so far this year, there's been very little correlation between credit spreads and the rate itself that we've seen so far.

Looking at the UK for example, the 10-year Gilt has reached as much as 50 basis points higher at one point on the year, whereas UK corporate bond spreads haven't traded outside of a 10 basis points range since the beginning of the year. And it's a very similar story for US and Euro Corporate Bond spreads, which have continued to tighten despite the arriving underlying yields. And so in terms of valuations, credit markets are very much assigning more weight to the rebound in global economic growth, the reopening of economies return of consumer demand and employment, which has been feeding into a recovery in corporate earnings and earnings forecasts and has been allowing corporates to de-lever and strengthen their balance sheets which were damaged during the pandemic and recover much of their credit metrics.

The risk to the downside for credit markets is really if the central banks lose credibility, that they can safely handle an overshoot of inflation if they find themselves needing to aggressively tighten monetary policy and bring forward their tapering of asset purchases and an extraordinary support more aggressively than has been expected - then that would likely drive more upward volatility in real yields, which would feed into weakness and credit spreads and credit markets.

But I think the key takeaway is that inflation in and of itself, isn't necessarily negative for credit spreads or for risk assets - but they are vulnerable to the tightening of financial conditions that result from aggressive monetary tightening as a result of sustained high inflation, and if we see a spike in real yields that can lead us to require higher risk premiums, higher spreads going forward. But for now, the market expenses is very much of this inflation scenario can be managed without aggressive tapering and we would certainly expect spreads to remain fairly range bound, going into the second half of this year.

Peter: So it appears that the risk markets and investors are placing their faith that central banks will be able to plot a course quite carefully and you know, and do it with great care, in terms of the way they conduct you know further central bank policy. And also, you know how they transmit or relay their intentions to the market in terms of what they plan to do, so no sort of taper tantrum type environment is probably quite key to the outlook for risk assets.

But looking through to these sort of underlying industry sectors and looking at what companies might be winners and or losers in an inflationary environment - so what type of businesses do you think would cope best with a higher inflation environment Jamie?

Jamie: It's a good question and I think it's probably important to look through into more of the detail of what inflation is leading through. We define inflation as the general rise in prices but typically in an inflationary period, some prices rise significantly, while others rise a little or not at all. So without stating the obvious, the effect in a company will depend on whether its input prices are rising faster or slower than the price of the goods or services it sells, and its ability to pass through those costs onto its end customers. And so it can help to look into the detail of what's driving inflation. And if we take this morning's UK CPI print, when the number was 2.1%, the main sectors driving that were fairly obvious ones such as transport, airfares, recreation and culture, clothing - these segments have been volatile over the past year as you would expect. And it's no surprise that they're showing a strong rebound in comparison to last year which was still during the strictest of lockdowns and closures and they are now seeing a release of a lot of that pent up demand. And it's these areas that should have a bit more pricing power over the second half of this year where there is that release of pent up demand.

But I think if we consider inflation from a very broad level - and the effect of an upward shifting yield curve - if we do see higher nominal yields and steeper yield curves as we would expect from an inflationary or reflationary environment. One of the more obvious sectors we would expect to outperform is banks and financials. Banks and money lenders - in very simple terms - their business model is to borrow short term and lend long term, so a steepening of the yield curve can help improve banks net interest margins, it can help their earnings and profitability and they've also been able to benefit from increasing demand for loans, increasing demand for investment that we see from the re-opening of economies and the upswing in GDP growth.

Similarly, within the financial space, insurance companies which have long dated liabilities to manage, an increase in long-term yields increasing the discount rate against those long-term liabilities, and so that can reduce the amount of capital that they're required to hold against them. We actually think valuations remain pretty attractive in the banking sector. We're comfortable to invest in more subordinated parts of bank's capital structures such as lower tier 2 bonds, where we've seen some attractively priced new issuance recently - particularly in the Sterling market. And these tend to be higher beta instruments, which offer more attractive yield and carry characteristics which we think offer sufficient compensation for their lower credit quality than more senior parts of the capital structure, and alongside the fact that the bank's issuing these securities should benefit from a reflationary scenario.

And then outside of financials in the corporate space, I think it helps to look at those companies that have stronger pricing power and more able to pass on those rising input costs to their customers more easily. And we've already seen a little bit about performance of the more cyclical sectors, such as base materials commodity producers and we've seen the price of several core commodities such as copper, iron or steel increase this year. And so metal and mining producers have been able to benefit from higher spot prices.

If you compare that to more defensive areas, such as food retail or beverage companies, they face a bit more pressure on their margins with less ability to pass these price increases onto consumers. And generally, this year we've seen the more cyclical industrials and these areas have outperformed the more defensive areas, such as food retail or utilities. And utilities is actually an interesting one, as bonds in this sector tend to be longer dated or longer duration - so they're more sensitive to changes in yields. If you're a water company or an electricity supplier, your projects tend to be quite long term in nature - hence why their debt will often be 10 years 20 years or even beyond 30 years antenna, so when yields rise or curves steepen, these long end bonds will naturally underperform their shorter dated equivalents.

Similarly, the real estate sector - or REITs- are more sensitive to changes in underlying rates or long-end yields, if that shifts upwards, the discount rates at which their properties are being valued. Although that can be offset by clauses in their rental agreements, which tend to be linked to inflation. And it also depends on what type of property you're operating - if it's discretionary retail or logistics centres, then those tend to be a bit more cyclical and will benefit from any rebound in economic activity.

And then if we look at other cyclical areas, such as the automotive sector for example. Something to consider with auto bonds is they tend to be more short dated in nature. The business model in their captive finance companies - so the financing arms of car dealerships - they behave a bit more like banks in offering financing to car buyers.

I think I read somewhere earlier this week, that there's now nine out of ten new car purchases in the UK are now made on finance, so their debt issuance tends to be shorter dated in nature. So, all else equal, would outperform in a scenario where credit curves steepen. And interestingly on the autos, anecdotally we also hear from our analysts based in the US, that the big auto names such as General Motors and Ford - which have both issued bonds in the Sterling and Euro markets - they've seen a very swift return in demand for their vehicles and recovering profit margins, despite a bit of supply disruption specifically due to the semiconductor chip shortage, which are a key ingredient when you make a modern vehicle. And the communications from these companies is that they're confident in seeing a return in semiconductor supply and production the second half of this year, so anecdotally that's just one example that lends a little bit of credence to this being more of a transitory inflationary period that will unwind as supply chains come back online, and there's more normalisation of demand. But I think the key thing to note is that everything I’ve talked about above is subject to inflation not overshooting beyond central bank's control and not resulting in central banks having to aggressively tighten policy. If that were to happen and if central banks found themselves behind the curve, resulting in tighter financial conditions and financing conditions causing a sell-off risk assets, we'd like to see the more defensive sectors such as utilities, such as consumer staples, food and beverage - outperform versus the more cyclically exposed area.

But for now, we think credit spreads should remain fairly range bound through the rest of this year. And so instruments with a bit of carry, a bit of yield, should be the key drivers of performance - whilst remaining relatively close to home in overall risk terms, given where valuations are at the moment at the tight end of their range.

Peter: Well thanks Jamie, I think it's fascinating the way that the broader macro environment for inflation filters down to impacting the micro sort of bottom-up elements of what companies or what sectors will fare better in an inflationary environment.

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