Inflation under control? What strategy should we adopt for our bond investments?

3 min read 23 Nov 23

Given the risk of persistent inflation and economic recession, we have opted for a neutral position in our portfolios to seize whatever opportunities might emerge. In our investment choices, we turn to the sectors we believe most capable of passing their rise in costs onto their customers. - Wolfgang Bauer, Corporate Bonds Portfolio Manager, M&G Investments

Getting inflation under control is the focus of economic news. And it directly influences the way we manage our bond portfolios. In the space of a year, the path has mostly been covered. The annual pace of change in consumer prices has slowed down considerably. Indeed, it slowed by more than 10% last year, down to levels much closer to the 2% target of the ECB (European Central Bank). At the same time, megatrends, like technological progress, especially in artificial intelligence, or demographic change, continue to exert deflationary pressure. An ageing population is more inclined to save money than spend it.

Too early to claim victory

Yet it is too early to claim victory. Despite this lull, which is encouraging, the outlook remains uncertain. Underlying inflation, excluding energy and food, still exceeds 4%, buoyed by wage demands. Other structural forces also suggest lasting inflation. These include the energy transition and deglobalisation, with plants relocating back to Western countries. Even if we can exclude inflation reaching a new peak, we now wonder whether prices are getting stuck above 2%. That is what we fear.

A gloomier economic climate

Unless inflation unexpectedly rises again, it is highly unlikely that the ECB will further tighten its credit conditions, having increased its rates by 450 basis points since July 2022. Otherwise, it could trigger a deep recession. The fact that it continues to reinvest payment from maturing securities under its pandemic emergency purchase programme (PEPP) suggests that it is choosing to remain cautious in a gloomier economic climate. Yet at the same time the central bank should stay vigilant in regard to prices by waiting longer and by not lowering rates prematurely. In short, the risk of persistent inflation and economic recession remains. No-one can reasonably ignore this.

In response, we have opted for a neutral position in our portfolios. The prices of corporate bonds are in our view satisfactory but not outstanding. We prefer to keep some leeway so we can adjust our exposure in accordance with market changes and so we can seize any opportunities.

Pricing power

The capacity of firms to pass their rise in costs onto their customers – and therefore protect their profit margins – is a crucial factor when we pick sectors for our investment choices. Food retail groups and companies in collective services, such as electricity network firms, stand out in this regard. However, telecoms operators, who are compelled to offer price reductions to keep their clients, are generally less resilient. Political decisions can also weigh upon the inclination of energy producers to put their prices up. This trend can be seen in France. And bonds in banking and insurance often offer prices that are more attractive than those in many industrial sectors.

Vigilance, patience and analysis

In conclusion, against this backdrop of uncertainty, our management approach is today based on vigilance, patience and diversification more than ever before. We rely on the expertise of a strong, experienced credit research team with whom we are in constant contact. Our approach requires the selective incorporation of new firms into our portfolios, based on in-depth assessment of their value and their risk-return ratio. Strict discipline and endless reassessment are vital in the face of market changes.

The information provided should not be considered a recommendation to purchase or sell any particular security. The value of the funds’ assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested . Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.

By Wolfgang Bauer

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