Inflation didn’t miss by much in the US – 3.2% versus 3.1% predicted. In the Eurozone, inflation climbed to 2.9% in December, from 2.4% in November, but was back down to 2.8% in January. In the UK, inflation rose marginally to 4% in December, up from 3.9% in November, after economists had predicted a slight fall.

Nevertheless, it has been enough to trouble the bond markets. The US 10-year treasury yield is back above 4%, and shorter-dated yields have moved even higher. The UK 10-year gilt yield has moved from around 3.5% at the start of the year to just under 4% today and the 2-year from 4% to 4.5%. This disrupts the view that government bonds are a one-way bet for the year ahead.

See also: It’s time for multi-asset managers to ditch bond proxies

The US Federal Reserve has pushed back on market expectations for a rate cut in March, saying that “the committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably towards 2%”.

Nevertheless, most believe that rate cuts are deferred rather than cancelled. Anthony Willis, investment manager on Columbia Threadneedle’s multi-manager team, says: “Chair Jay Powell spoke positively about the progress made so far but said there was a need to have more confidence on the disinflation path”. The Fed is “not looking for better data, but a continuation of the better data” that has already been seen. Powell said that a March cut is not the most likely case, because the committee is unlikely to have hit that level of confidence by then.

“Futures markets are pricing only a 35% probability of a cut in March – though the Fed will have two more inflation data points to digest by then. Powell’s comments suggest that if inflation remains on track, then even if March is not likely, rate cuts are coming soon,” adds Willis.

See also: Facing the inflation dilemma head on

Jim Leaviss, manager of the M&G Global Macro Bond fund, also believes rate cuts are still likely: “Inflation has started collapsing – both core inflation and headline inflation. The numbers that the Fed looks at – core PCE inflation – are back down towards 2%. It is going in the right direction.”

Inflationary risks

That said, Leaviss also believes there may be longer term risks to the current benign inflation picture, particularly in the US. He points out that there is usually a balancing mechanism for government debt. Governments borrow more when the economy is weak; and when the economy is weak, inflation is falling and interest rates are generally coming down as well.

However, he adds, “this relies on a world in which governments borrow more when economies are weak, not where they borrow more to juice an already strong economy.” The US has seen two quarters of 4-5% growth, and its employment market is very strong. Nevertheless, he believes that widespread disgruntlement with rising prices is likely to usher Donald Trump into the White House, and that tax cuts are likely to be his priority once he gets there.

Tax cuts have historically been a significant contributor to rising debt to GDP. Leaviss says Trump’s election is likely to be inflationary and the US government will have to borrow more at higher bond yields.

Inflation protection?

Charlotte Yonge, assistant manager on the Personal Assets Trust, is also alert to the risks inherent in US borrowing: “The US government is spending money like it’s going out of fashion. This has provided a great fillip to growth. The fiscal deficit – the amount by which government expenditure exceeds receipts – was $1.3trn for the first three quarters of 2023, or nearly 5% of GDP.  We have never seen this level of government spending outside of a recession or its immediate aftermath.  On a gross basis, the fiscal outlay relative to the size of the economy is approaching a level consistent with the peak in government support provided during the Second World War.”

She believes this phenomenon is consistent with a multi-decade long trend and is not unique to America.  It is both a symptom and a cause of lower pain thresholds on the part of electorates around the world. She adds: “We expect that the next recession will see a fiscal response on top of a monetary one, such that the benefits extend beyond owners of capital to labour as well. This, as we saw with Covid, is likely to mean inflation for goods and services on top of asset price inflation.  Governments’ increased readiness to respond to economic hardship will help define the shape of the next recession and subsequent rates of inflation.”

The consequence of this shift is likely to be more volatile and structurally higher inflation than we have experienced over the course of the last 10-15 years. In response, the trust now has around 40% in index-linked bonds, mostly in the US. This is well above the trust’s long-term average of around 30%.

For Leaviss, the bond market is still good value, and they are keeping a watching brief on the election outcome. He adds: “The Fed says that long-term interest rates, based on demographics, technology, globalisation, and those long-term factors that determine how much we save and invest, will be around 2.5%. The treasury market thinks it’s more like 5%. We’ve never seen this degree of dislocation.” As a result, he is focusing on longer duration government bonds, believing this is where the opportunity lies.

Bonds markets have re-set since the start of the year and now reflect less optimism on rate cuts and falling inflation. Inflation is unlikely to bounce back significantly, but there are always unpredictable elements, such as the oil price, and markets are jumpy. It can still be the year of the bond, but investors will need to be selective.

This article was written for our sister title Portfolio Adviser

Value stocks have underperformed growth for much of the last decade, but Adrien Pichoud, manager of the Oyster Absolute Return fund, said investors should expect the “vast chasm” between the two styles to further close as the dynamics for a reflationary environment remain in place.

“We believe the world will remain in a low growth, low-rate environment,” said Pichoud. “But there will be periods where inflation increases due to an evolving and volatile macroeconomic picture. We are now experiencing such a reflationary spike, and this may accelerate and continue for some months to come.”

So what is causing this spike and which assets will be most effected?

Consensual trade

Pichoud said that while business activity in the eurozone contracted again in February, as lockdown measures restricted the bloc’s dominant service industry, key surveys indicate factories had their busiest month in three years.

“This is a positive development underlining that while overall business activity may be subdued or even deteriorating, it is not collapsing as was the case in the first lockdown, when the world’s economies fell into the abyss,” he said. “This means the dynamics for the reflation scenario remain in place, both in terms of growth and inflation.”

Indeed, Pichoud added a firm bounce-back is now arguably the consensual trade and that a boost to this narrative is the introduction of strengthening economic data coming from the US in terms of household consumption.

“The fiscal stimulus cheques now arriving through the door will further strengthen purchasing power and should lead to an acceleration in demand during the spring,” he added.

Good for equities

According to Pichoud, this scenario will provide a constructive platform for equities – particularly in cyclical sector and among classic value plays; such as industrials, materials and financials. In parallel, he is cautious on global fixed income assets, given renewed momentum in long-term rates, while he added technology and quality equity names will continue to be buffeted.

“With this backdrop in mind, we have continued what we started last November – repositioning the portfolios towards more cyclicality, reducing technology stocks and adding to financials, materials and industrials,” he said. “This has allowed us to take profits and reduce our tech exposure, some of which was adversely impacted by the rise in long term interest rates.”

Pichould has also added to his fund’s financials position as a way of getting global exposure to banks that will benefit from rising interest rates.

“Their massive underperformance in the last decade will probably never be fully recouped, but we are at a tactical inflection point, and a reflationary mini-cycle will be a big tailwind for the sector,” he said.

How long and how much?

Ryan Hughes, head of active portfolios at AJ Bell Investments, said while he is not in the camp of expecting inflation to get out of control, he does believe that it now seems clear inflation will shift higher and in all likelihood, stay slightly elevated for some time.

“After all, the Federal Reserve has told us they are comfortable letting it run hot for a little while before they plan of raising interesting rates to rein it in,” he said. “The key question is when is this point reached and what will the magnitude of change be.”

Like Pichould, Hughes said this should be good for cyclicals and will likely mean the current value rally continues, not least because it still remains hugely undervalued versus growth after such a long period of underperformance.

“We recently added energy stocks to our portfolios alongside some existing positions in value managers to benefit from this and see no reason to lock in short-term profits at this stage,” he said.

While equities and the return of inflation look well supported in the coming months, Pichould added that he is always keeping an eye on anything that could threaten this scenario. This, he said, also means keeping the fund’s protections in the market, so if the market experiences an acute drawdown, its losses will be limited.

“In the scenario where rates move far faster than the market expects, we could see some strong market gyrations, and it pays to have the appropriate market protections in place,” he said. “We also maintain a gold position. A safe course means never sailing too close to the wind.”

Five years on, as central banks phase out quantitative easing and tighten monetary policy, it is reasonable to assume that emerging markets will get hit by similarly capricious capital outflows.

Investor interest in the developing world has been sky high. Foreign investment in emerging markets jumped 54% last year to €191bn (£167bn, $226bn) and the lion’s share (€138bn) was in emerging markets debt, according to the Institute of International Finance.

“The stars were in near-perfect alignment for emerging market debt investors in 2017,” says Colm McDonagh, head of emerging market fixed income at Insight Investment.

“Sovereign and corporate spreads tightened by 57 basis points and 43bp respectively, and local currency yields ended 65bp lower.”

But as US Treasury yields rise and market volatility increases, will these robust foreign inflows continue?

The Fed raised its benchmark interest rate by a quarter of a percentage point in March – the sixth hike since near-zero levels in 2015 – and new Fed chairman Jay Powell suggested the pace of future hikes could be more aggressive amid positive economic tailwinds.

The market expects a further three or four rate rises this year.

Improved fundamentals

In the past, such a sharp increase in the cost of borrowing would have spelt trouble for the developing world (take, for example, the Mexican debt crisis in the mid-’90s when a Fed rate hike left the country unable to service its dollar-denominated debts.)

However, Liam Spillane, head of emerging market debt at Aviva Investors, says the impact of rising rates on emerging markets is not the harbinger of doom it once was.

“Emerging market fundamentals are more robust than they’ve been for years,” he says.

Emerging markets on JP Morgan’s GBI-EM index have generally seen a pickup in growth, a decline in inflation and improved current account balances in recent years.

Currency valuations are fair and monetary policy measured. Corporates generally have strong balance sheets – as evidenced by low leverage levels and high cash balances – and default rates on emerging market credit are at record lows.

Part of the reason for emerging markets’ robust performance over the past year has been the synchronised global growth outlook.

The IMF forecasts global growth of 3.9% this year and next – up 0.2% on 2017.

“Emerging markets have benefited from a favourable economic backdrop characterised by good economic growth momentum, healthy inflation dynamics and solid exports,” says Gergely Majoros, a member of investment committee at Carmignac.

“The positive growth outlook and favourable US financial conditions are expected to further support capital flows into emerging markets assets.”

The weak dollar – which has fallen more than 13% against the euro since the start of 2017 – has helped stabilise commodity prices, which has boosted emerging economies.

Commodity prices have risen 30-40% on average from the lows of 2015.

The political situation, meanwhile, is improving in many countries. Indian prime minister Narendra Modi’s pro-business reforms and new South African president Cyril Ramaphosa’s anti-corruption agenda should boost investment opportunities.

“Structural reforms in commodity producing countries have contributed to significantly improved current account balances,” says Majoros.

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Law firm Stephenson Harwood has appointed Laurence Ho as a partner in its Hong Kong private wealth team.

Ho’s practice is focused on international tax, trust and estate planning matters for high net worth individuals, families, estates and fiduciaries. He has considerable experience advising on US expatriation and pre-immigration matters, as well as counselling individuals and families on their US tax compliance and foreign bank account reporting obligations.

Ho joins from Withers where he was a partner.

Julius Baer International

International Adviser can exclusively reveal that Daniel Savary, sub-region head of Eastern Mediterranean, Middle East & Africa (Emmea), has left Julius Baer International.

Savary was deputy to Rémy A. Bersier, region head.

Prior to January 2016, when Gerassimos Spyridakis joined Baer as head of a newly created sub-region Africa & Eastern Mediterranean, Savary had been head of Emmea markets, a role he had held since 2012.

Additionally, Julius Baer International is continuing its UK expansion in Manchester, Leeds and Scotland with a raft of hires from Barclays Wealth. New joiners include relationship managers and wealth planners as well as a number of support staff.

Julius Baer’s new premises will be opening in Leeds and Manchester this year and in Scotland, early next year.

Key hires include:

• Glenn Branney as regional head of wealth planning, reporting to UK and Ireland head of wealth planning, Alan Hooks.
  Martin Cuthbert as north-east team head.
• Gordon Scott as head of the teams covering the north-west, Scotland and Northern Ireland and will be based in Scotland.
• Andrew Miller, Jonathan Dobbin and James Bailey as senior relationship managers.
• Charlie Hague, Mark Embley as a relationship managers.
• Simon Patterson joins Baer’s north-east team with responsibility for Newcastle and the surrounding area.
• Existing advisers Jonathan Holland and Robert Websdale, will relocate to Manchester.

Intertrust

Intertrust, a global provider of high-value trust, corporate and fund services, has appointed Sara Jonker-Douwes as managing director of Intertrust Netherlands and member of the executive committee of Intertrust Group, subject to regulatory approval.

Jonker-Douwes was previously chief executive corporate services continental Europe and managing director Netherlands at Link Group, an Australia listed fund and corporate services provider. She joined Link through its acquisition of Capita Asset Services, where she worked since 2013.

Brewin Dolphin

Brewin Dolphin has appointed Mike Kellard to its board as a non-executive director.

Kellard was Axa Wealth’s chief executive until 2016, departing shortly after the division was bought by Phoenix Group.
The appointment will be effective from 1 December 2017.

Brabners

Law firm Brabners has boosted its family team with the appointment of Richard Rigg from DWF.

Rigg, who joins as an associate in the Liverpool office, has five years’ experience in family law, with particular expertise in divorce and complex financial settlements arising from relationship breakdown. Rigg will strengthen the team’s wealth protection offering for its high net worth and business clients.

Brabners’ family team is headed by partner Helen Marriott.

So far in 2017, partner senior appointments include Steven Appleton as head of private client practice and Ian Mylrea as head of the firm’s pensions team.

BNP Paribas Asset Management

BNP Paribas AM has appointed Roger Miners as chief marketing officer, replacing Anthony Finan who will pursue personal opportunities outside the BNP Paribas group.

Miners will be based in London and will report to Sandro Pierri, global head of client group, BNPP AM’s worldwide sales and marketing organisation.

Miners most recently held the position of chief marketing officer at Allianz Global Investors, where he spent 15 years in sales and marketing leadership roles.

Federal Reserve

Fed chair Janet Yellen submitted her resignation on Monday as a member of the board of governors of the Federal Reserve System, effective from 3 February 2018 upon the swearing in of her successor.

She was appointed to the board by president Obama for an unexpired term ending 31 January 2024.

“It will be a person who hopefully will do a fantastic job,” Trump said, adding that he has “someone very specifically in mind”.

As he says about all of his enigmatic plans and proposals on healthcare reform and corporate tax, which have failed to get off the ground: “Everyone will be really impressed.”

Jay Powell, who has been on the Fed’s board of governors since 2012, has been cited as the front-runner by most publications. But Stanford economist John Taylor has also been identified by the Trump team as a top pick.

Powell is by far the “continuity candidate,” a centrist who has shown unwavering support for Yellen’s approach to slow and steady interest rate hikes and minimising the government’s $4.5trn (£3.4trn, €3.9trn) asset holdings. Taylor, on the other hand, is the wild card, but nevertheless a respected thinker in the industry who current chair Janet Yellen admits has paved the way for the shape of current monetary policy.

Like so many other things about the Trump administration, the build-up to the reveal of the next chair of the Federal Reserve is completely unprecedented.

As others reporting on this event have noted, the practice of selecting a new Fed chairman, while a paramount political decision, is generally accompanied by little to no fanfare.

By contrast, Trump’s treatment of this time-honoured tradition has the trappings of a low-brow reality TV programme. Powell versus Taylor – who will be the survivor? Who will be the lucky recipient of the final ceremonial rose? Or will there be a shock twist ending? Will Yellen file into the boardroom unannounced to be told: “You’re (re-)hired”?

‘An historic appointment’

But this choice is something which shouldn’t be taken lightly nor done for higher ratings, says David Coombs, head of multi-asset at Rathbones.

Coombs views the pick of the next chairman as “vital” on the basis that the person chairing the Fed is “one of the most powerful people in the world”, arguably “even more important than the politicians”.

“Right now, given where we are, nearly 10 years off the financial crisis and the unwinding of emergency measures, this is a historic appointment and the impact on the money markets and the stock markets could be huge,” says Coombs.

Though he suspects Trump will veer toward the “safe choice” i.e. Powell, “trying to predict what Trump will do is fraught with danger”. After all, “he likes to break the status quo and the elitist consensus”.

The best way to accomplish that would be to elect Taylor, who Coombs says “would almost definitely be more hawkish”. “That could have a significant short-term impact on markets. I suspect it would send bond yields higher quite significantly and equity markets lower.”

Fed will stay the course

Seven Investment Management investment manager Ben Kumar begs to differ over the importance of Trump’s pick. The “Fed is on course”, he argues, and unlikely to deviate no matter who happens to be sitting in Yellen’s chair when she (more likely than not) relinquishes her crown in February 2018.

“When you have a large institution and you aggregate all of their knowledge, it tends to be done along pretty orthodox lines. If someone comes in and says, ‘Yellen is completely wrong, we need loads more money and the economy is actually buggered’, that’s not something they can do particularly easily without upsetting the markets.”

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