All around the world, fund managers appear to be gearing up for an era of low inflation. Unless, that is, they are investing in the UK.
Market expectations of inflation in the US and the eurozone have tumbled in recent months, helping to drive a record-breaking global rally in bonds. But the landscape in the UK is radically different: investors are pricing in inflation well above the Bank of England’s 2 per cent target for the next decade and beyond.
“In a world where inflation expectations are collapsing, the UK stands out,” said Mike Riddell, a fund manager at Allianz Global Investors.
This status as a global inflation hotspot puts the BoE in the unusual position of trying to tame expectations of price rises, while other central banks — particularly in Japan and the eurozone — are struggling to steer expectations higher, amid concerns that global growth is waning.
The UK’s predicament is partly because of uncertainty over Brexit, as well as a reflection of the unique needs of the country’s pension fund sector. Even so, some investors who doubt that Britain’s fortunes will diverge materially from other developed economies see an opportunity to profit.
“The inflation market is mispriced,” said James McAlevey, head of rates at Aviva Investors, which manages a total of £346bn in assets. He is betting that inflation over the next 10 years will be lower than that currently implied by markets.
Why has Britain moved so far out of line with its peers? The planned exit from the EU has a lot to do with it. Sterling tumbled after the referendum on membership in June 2016, driving up the cost of imported goods and unleashing a wave of consumer price rises which pushed CPI above 3 per cent in 2017.
Investors are worried about a repeat performance from the currency if the UK crashes out of the EU without a deal in the coming months. Oliver Harvey of Deutsche Bank thinks the market is currently pricing in a more than 50 per cent chance of a no-deal Brexit, as judged by the market for inflation-linked bonds.
Longer-term inflation expectations, however, are less easy to explain away. Central banks, including the BoE, favour a market measure of what five-year inflation expectations will be in five years’ time, to gauge how sticky price rises are anticipated to be. By focusing on this measure — known as the five-year, five-year swap rate — they attempt to iron out short-term influences like fluctuations in exchange rates or oil prices. Even here, however, the UK sticks out.
UK 5y5y inflation currently stands at 3.6 per cent, nearing its highest since the financial crisis. In the eurozone, meanwhile, a similar measure touched an all-time low of 1.1 per cent this week, while US expectations have collapsed this year close to a record low at just above 1.9 per cent.
There is a wrinkle to the international comparison: UK inflation markets are based on changes in the retail price index, which consistently run nearly a percentage point higher than the more commonly used consumer price index. But even adjusting for this, UK inflation implied by swap rates is running at about 2.7 per cent.
Curiously, this rate has tended to surge when Brexit-related fears hurt the pound, even though any exchange rate impacts on inflation should have faded long before five years is up.
If anything, a messier Brexit should imply weaker growth, and therefore lower inflation, in the long term, argues Michael Krautzberger, head of European fundamental fixed income at BlackRock, the $6.8tn-in-assets fund manager.
“It’s tough to explain why UK inflation expectations should be at these elevated levels,” said Mr Krautzberger, who is shorting five-year, five-year inflation swaps in his portfolios.
Some analysts caution that it is a risky bet to assume that UK inflation markets will move back in line with those of the US or eurozone. They argue that instruments like inflation swaps and inflation-linked bonds or “linkers”, whose interest payments are topped up according to inflation rates, do not truly reflect investors’ expectations of inflation in the long term.
Instead, the elevated swap rates are a function of the unusually large array of defined benefit pension funds in the UK, which are obliged to increase their payouts to pensioners in line with price rises.
That creates an outsized demand for products like swaps and linkers which can be used to hedge against inflation. The result is a persistent premium on the price of inflation protection in the UK compared with other markets, according to banking group Société Générale’s head of inflation strategy Jorge Garayo.
“These rates are mostly driven by the technicals of the market,” Mr Garayo said. “Should the UK be worried about being the inflation guys? I don’t think so.”