Europe’s Inflation Spurt Has Jupiter, Carmignac Seeking Refuge
Ballooning energy prices are giving fresh support to a view that has been all too rare in Europe’s bond markets for more than a decade -- that inflation is back and it’s not going away any time soon.
Jupiter Asset Management and Carmignac Gestion are among a growing legion of investors that say there’s a risk the current price pressures in the euro region could be more than just transitory, and as such could shake the land of negative yields.
While none are predicting runaway inflation just yet, they say the landscape is being altered by the spike in energy costs, with everything from natural gas to carbon permits jumping to records this week. And as the European Central Bank remains relatively sanguine on inflation versus the Federal Reserve, there’s a danger that yields on euro-region bonds are about to surge, slashing the spread between German bunds and U.S. Treasuries.
Mark Nash, who heads fixed-income alternatives at Jupiter Asset Management in London, says the gap may narrow to 100 basis points by early next year. It’s currently about 173 basis points.
“I short all bond markets, but the one that I short the most is the European bond market,” Nash said in an interview. “Global growth is now looking more balanced. Output gaps are closing. The pandemic situation has improved. Europe is part of that global picture, but the market has until recently priced in no change in ECB policy over the next five years. I find that difficult to understand.”
See: Treasuries Aren’t Even Trading Inflation Risk (Yet): Macro Man
Policy makers around the world are becoming increasingly alert to inflation risks as economies emerge from the ravages of Covid-19. The Fed warned last week it may taper bond-buying soon, while the Bank of England said Monday it may raise interest rates before the year is out.
The ECB hasn’t been so vocal. Though Governing Council member Gabriel Makhlouf said Wednesday the bank must be ready to respond should supply bottlenecks drive longer-lasting pressures, other policy makers have spoken more about the need to support the post-pandemic recovery. On Tuesday, ECB President Christine Lagarde said there’s no sign that the surge in prices is becoming “broad-based,” attributing half of total inflation today to energy.
Nash isn’t taking any chances. As well as going short European bonds this month -- and adding to that position after last week’s Fed meeting -- he’s holding European inflation-linked securities, or breakevens, betting that the jump in energy prices is about to spill over into wage growth.
“With inflation prints expected to range between 3% and 4% for the next six months, investors are likely to be looking for protection,” said Kevin Thozet, a Paris-based member of the investment committee at Carmignac, which is also long 10-year European breakevens.
While the German 10-year breakeven rate is at an eight-year high of 1.67%, it’s destined to go higher still as demand for hedging increases, according to Thozet.
“Inflation risk in the eurozone is currently underhedged,” he said.
What’s obsessing investors is whether the surge in energy prices will lead to increases in taxes, rents and other items -- so-called second-round effects that make inflation more enduring. Rising oil and gas prices probably contributed 1.4 percentage points to euro-region headline inflation in August, according to Goldman Sachs Group Inc.
Should reports continue to indicate inflation is taking hold, the alarm bells may sound even louder. Germany’s reading on Thursday jumped to 4.1%, the fastest pace in nearly three decades. Inflation for the wider euro region, to be published Friday, is forecast at 3.3%. The ECB’s inflation goal is 2%.
Some big-time investors aren’t moved. Iain Stealey, international CIO for fixed income at JPMorgan Asset Management in London, says the path toward normalization is more clear-cut in the U.S. and U.K., so he’s underweight U.S. Treasuries and gilts. BlackRock Inc., Wall Street’s biggest asset manager, prefers U.S. Treasury inflation-protected securities over their European peers, judging euro-region inflation will remain contained.
“It should be kept in mind that realized inflation stands at just 1.6% on average since the inception of the ECB in June 1998,” Jean Boivin, head of the BlackRock Investment Institute in New York, and London-based Elga Bartsch, head of macro research at the firm, wrote in a Sept. 16 report. “That makes the ECB’s re-underwriting of an inflation target of 2% look somewhat ambitious despite the current post-pandemic inflation spurt.”
For Martin van Vliet, a strategist at Robeco in Rotterdam, the spike in inflation brings back memories of 2008 and 2011, when the ECB was forced to hike interest rates.
This time though, the central bank is more likely to make adjustments to two quantitative-easing programs running in the background. Which is why Robeco’s global macro team is staying long on inflation-linked bonds.
“We have to be open to the possibility that it may be here longer than we thought, and that we are going to see second-round effects,” van Vliet said. “We can’t rule out the possibility that the ECB will reduce stimulus sooner than what the market has priced in.”
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