Higher inflation: ‘transitory’ or here to stay? This has been the most hotly debated question of 2021. The US consumer price index (CPI) hit 6.2% in October, rising at its fastest pace in three decades, while in the UK, inflation has been running above the Bank of England’s 2% target for six months and recently jumped to 4.2%.
Fixed income heavyweight Mike Riddell (pictured) and his cohorts on the Allianz Global Investors macro unconstrained fixed income team are firmly in the ‘transitory’ camp. He has even gone so far as to short UK inflation in his Allianz Strategic Bond fund.
“We don’t believe in this new higher inflation regime some people are arguing for,” he states. “Cyclically, in the short to medium term, growth should remain strong, but I think that will start to come under pressure from the first quarter of next year.
“Structurally, if you look more like 18 months ahead, my assumption is that the growth numbers are going to go back to what we saw in 2018/19, if you’re lucky, and inflation numbers from the end of next year should be going back towards central banks’ target levels.”
Riddell not planning to rein in UK inflation shorts
Explaining his short position, which is expressed via UK inflation swaps, Riddell says that compared with other markets where inflation rates have been priced in around fair value, the UK still looks extremely expensive.
During the past several months this view has proved costly, losing the £2.9bn fund 2% from the end of July alone, as surging gas and energy prices and global supply bottlenecks have driven up inflation expectations. In September, the five year implied UK RPI swap rate was the highest since data began in 2004.
However, Riddell is not planning on making any changes to his short UK inflation position and remains confident these effects are a temporary phenomenon.
Ironically, Riddell’s inflation calls were among the biggest generators of returns in the second and third quarter of last year. At the end of March 2020, he went aggressively long of US inflation, also expressed via swaps, and added a eurozone inflation position at the end of Q2 2020.
“At one point, the market was pricing in two years of deflation, which is just amazing if you think about what’s happened in the past 18 months,” he says.
Allianz Strategic Bond’s pandemic-defying performance
Riddell is coming off a stonking performance in 2020. Serendipitously, he went into the year extremely defensively positioned, with a bit of government bond duration, long positions in the US dollar and Japanese yen, and severely underweight corporate bonds to the point of being outright short. “We thought there was a risk of a big volatility shock, the risk of recession, but most importantly, that wasn’t priced into markets at all.”
Allianz Strategic Bond was the only vehicle in the IA Sterling Strategic sector to deliver a positive return during Q1 2020. The fund was up 12.5%, while the average fund lost 6.4%, according to FE Fundinfo. Its pandemic-defying performance caught the attention of fund buyers who poured money into the fund, helping Allianz GI rake in £570.5m in net inflows in the first three months, its best ever quarterly sales figures for UK-domiciled funds.
Launched in November 2015, shortly after Riddell joined the company from M&G Investments, the fund seeks to outperform the Bloomberg Barclays Global Aggregate (sterling hedged) index over three years but also deliver asymmetry relative to the benchmark.
It strives to behave like a bond fund by targeting zero correlation with MSCI World Equities and foregoing income or yield targets, which provoke long-risk bias. This helps differentiate it from its peers, that often tend to be exposed to riskier corporate bonds regardless of the market environment, meaning that they behave more like equities.
“The whole point of a strategic bond fund is it’s supposed to be flexible, you move it around as things happen and there is change in the global economy,” Riddell says.
By the third week of March 2020, Riddell believed signs pointed to a v-shaped recovery and loaded up on corporate bonds and other beaten-up risk assets that would benefit from the reflation trade. But in the summer, he started cutting his investment-grade credit exposure and by December had sold almost all of it.
Markets underestimating ‘double whammy growth shock’
Speaking to the former M&G bond manager today, his fund is defensively positioned once again, albeit not as severely as at the start of 2020. Duration in the fund is just under four years, below its seven-year benchmark and just shy of its shortest duration ever.
“We’re not as worried as we were pre-Covid, where we could see an imminent catalyst for a huge sell-off. I’m not saying it’s quite that severe, but it feels like risky assets again are pricing in strong growth forever, and that’s just not what we expect going into the middle of next year.”
Though Riddell is not currently worried about inflation spiralling out of control, he is concerned about the ‘stag’ element. While markets have priced in higher inflation, they are underestimating the “double whammy growth shock” that could come from the Evergrande fallout in China and the energy crisis.
In the case of Evergrande, investors have been chiefly concerned the liquidity woes of the Chinese property giant will spill over into the wider sector. But real estate accounts for 30% of its domestic economy, which in turn has accounted for 30% of global growth in the past decade.
“Indirectly, China real estate is responsible for around 8% of global growth of the past decade,” Riddell says. “If China’s real estate market is having a semi-controlled implosion, that is not going to be good for Chinese growth, obviously, and it’s not going to be good for global growth either.”
Government bond sell-off should ease up
Similarly, he believes investors may only be thinking about the impact of rising commodity prices on inflation, not global growth.
Jumps in energy prices have been known to trigger recessions before, the most famous example being the global financial crisis, says Riddell. The subprime mortgage crisis may have been the catalyst that sent markets reeling, but it was rising oil prices, which doubled in the first half of 2008, that “pushed the global economy over the edge”. During the past 12 months, the price of Brent crude has doubled from an average of $40.19 (£29.12) a barrel last October to $85.66, and alongside that, gas prices have quadrupled.
On top of this, central banks have signalled they will be less stimulative and will begin raising interest rates, with the Federal Reserve and Bank of England pencilling in three hikes each by the end of 2022.
For this reason, he doesn’t expect government bonds will sell off much more in the next few months. “If we start getting the risk of recession, we do not expect to see government bond yields continuing to rise at the rate they have over the past couple of months.”
Even if equity markets wobble, Riddell believes central banks will follow through and taper. UK CPI could easily reach 5% in the first or second quarter next year, so refusing to tighten policy would destroy the Bank of England’s credibility and risk a massive sell-off in sterling.
Emerging markets still look attractive
The only area in risky assets Riddell says he still finds attractive is emerging markets. He started buying more local rates and currencies in Q4 2020 and Q1 2021 on the basis that valuations were cheap and some Latin American countries would benefit from the huge run in commodity prices.
While valuations still look incredibly cheap, his conviction has wavered due to renewed fears over China and a global growth slowdown. In September, he cut the fund’s exposure to emerging markets FX, closing his position in the Mexican peso, and reducing exposure to the Brazilian real and the Chilean peso.
“We still own some emerging markets, but not as big as we had before,” Riddell explains. “Going into December, 20% of our fund was long emerging market currencies, and now it’s more like 12 or 13%.”
Instead of shorting emerging market currency positions against the US dollar, Riddell prefers pegging his long positions against the Chinese renminbi and Korean won, currencies that would slump in the event of an Asia slowdown and “look pretty expensive anyway”.
Riddell’s team mulls future fund launches
Over the last year Riddell’s macro unconstrained fixed income team has been growing. While his Allianz Strategic Bond co-manager Kacper Brzezniak has left, three new hires have come on board the £7.5bn team, which now stands at six strong.
Looking ahead, Riddell says the team is having conversations about launching new funds.
“One of the one of the reasons we were given the green light to hire additional people is that we’ve been getting reverse enquiries from people to launch certain inflation funds,” Riddell says.
“We haven’t got to the point where we’re actually launching funds but we’re certainly thinking about it.”
This article is taken from the November 2021 issue of Portfolio Adviser. Read more here.
