“What was bound to happen finally happened. After years of unseen reflation policies around the world inflation started to swing higher. In particular US spot and forward inflation indicators swung higher post the presidential elections in anticipation of additional fiscal support while a weakening currency pushed UK inflation higher to 1.8% and potentially even rising higher over the coming months. Higher commodity prices helped to lift European inflation metrics. One might argue this is mainly a cyclical phenomenon. Agreed, cyclical forces are at work, yet we think it would be unwise to ignore the slow-motion mechanics of the output gaps which are closing. Indeed forward-looking references such as the break-even inflation have also moved higher in both the US and the euro area to 2.4% and 1.8% respectively. This has clear implications for long-term investors as far as assets are concerned as well as on the liability side (casualty losses being correlated with inflation):
• First, inflation returning back to ‘normal’ should lift bond yields higher, which argues in favour of real assets (long lease property, infrastructure debt etc.). Indeed equities can offer an inflation hedge with one big caveat: high volatility imposes elevated capital requirements. A systematic and disciplined overlay management protecting potential downside risks, offers an elegant and viable solution.
• Second, inflation-linked bonds, at least US-linkers, seem to us a ‘must have’ given a tight labour market and gently rising labour costs. In that regard, the euro area is far behind. With a slowly improving market and growth in the vicinity of 1.5% the output gap may slowly reduce.
• Third, as the economic cycle matures, portfolios could be enriched with uncorrelated and less liquid assets (e.g. insurance-linked securities) to offer some protection against rising volatility.
• Fourth, inflation swaps can help to protect against inflation rises on casualty losses.”
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