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Analysis

Spectre of inflation flare-up threatens historic bond rally

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Bond investors are braced for the risk that 2021 could herald the return of a long-dormant foe: inflation.

The price of government bonds has rocketed this year, largely because of the huge bond-buying programmes undertaken by central banks to soften the financial impact of the pandemic. Investors are assuming this support continues, even as economies pull out of their 2020 slump.

A rebound in inflation, which has been elusive since the 2008 financial crisis, could disrupt these widely held expectations by making the debt market look less attractive. Bonds typically provide investors with a fixed stream of interest payments, which become less valuable as the overall cost of goods and services accelerates.

If price pressure finally erupts, it would also ricochet through riskier assets. The 2020 rally in global equities has been powered by the rise in bond prices, which has pushed borrowing costs to historic lows and eased jitters over the widening gulf between stock prices and corporate profits.

“Inflation staying low and well-behaved is the foundation on which everything in markets is currently priced,” said Karen Ward, chief market strategist for Europe at JPMorgan Asset Management. “Investors’ assumption is that central banks will be able to stay accommodative well into the economic recovery. If inflation picks up in a way that’s not expected, that would challenge the market’s entire view.”

Line chart of Barclays Multiverse yield (%) showing Global borrowing costs have dropped to historic lows

Concerns about a potential inflationary burst are gathering pace particularly in the US, prompting some speculation that the Federal Reserve could be compelled to withdraw its support sooner than indicated.

The shift in market pricing is subtle but significant. In the eurozone, inflation expectations remain far below the ECB’s target of just below 2 per cent. But the 10-year US “break-even” rate — a proxy for investors’ expectations over the next decade — is rising. It has climbed from below 1.6 per cent in September to about 1.9 per cent, putting it at the highest since May 2019 and just below the Fed’s average inflation target of 2 per cent.

The chance of inflation skittering out of control is low, analysts said. With the pandemic causing unemployment to surge, it may be some time before workers are in a position to push for wage increases. And even once labour markets heal, the long-running demographic and technological shifts that many economists have said depressed inflation over the past decade remain in place.

BlackRock’s Bob Miller, who heads up its fundamental fixed income team for the Americas, is among those who worry that experience has left investors “complacent” about the prospect of consumer price increases in the coming year. And now, with bond yields sitting at depressed levels, the room for error is very limited.

“The market is a little bit hung up on the last decade’s experience,” he said, adding that investors should buy assets that protect against inflation on a two to four-year time horizon.

Line chart of US 10-year break-even rate (%) showing US inflation expectations climb as investors await economic recovery

His argument rests on the pivot from the Fed earlier this year. The US central bank said in August it would tolerate higher levels of inflation to make up for the prolonged period in which consumer price increases have faltered below its target, a switch from its previous policy of pre-emptively raising interest rates to stymie inflation above 2 per cent.

Market participants reckon this means US interest rates, which exert a gravitational pull across all assets, will remain tethered to zero at least into 2023.

But once Covid-19 vaccines are widely distributed, businesses and consumers could unleash a jolt of pent-up activity. “The stars are aligning to put the economy on a pace for a robust recovery,” said Sonal Desai, chief investment officer at Franklin Templeton’s fixed income group. “That sets us up for definitely some inflation in the second half of next year.”

Investors are taking cover. Demand for Treasury inflation-protected securities has surged in recent weeks, with roughly $4.5bn poured into relevant funds since the beginning of November, according to EPFR.

The prospects of resurgent inflation already has investors seeking out alternatives to ultra-safe assets like Treasuries, sending prices lower and yields higher. Benchmark 10-year Treasury notes now yield about 0.9 per cent, having traded below 0.7 per cent less than three months ago. Analysts’ forecasts suggest they will hit 1.2 per cent by the end of next year, according to Bloomberg data.

Column chart of Weekly flows into US funds buying inflation-protected securities ($bn) showing Demand for inflation protection soars

Some investors question whether any pick-up in inflation would last, citing not only the scale of the coronavirus economic shock and the recent resurgence in cases, but also the failure of US policymakers to agree on additional fiscal support.

Steven Oh, global head of credit and fixed income at PineBridge Investments, thinks a likely rise in inflation in the spring should be fleeting and largely ignored by investors and central bankers alike.

Assuming central bankers will look the other way comes with considerable risks, however. Historically high prices of both bonds and stocks are premised on expectations of years of rock-bottom interest rates, and both could tumble if the Fed signals even a chance of higher borrowing costs, according to Shamik Dhar, chief economist at BNY Mellon Investment Management.

“That’s a world where fixed income stops being a hedge for equities, and both sell-off together,” he said. “That would be a big shock.”



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Analysis

Signs of inflation emerge as Chinese producer prices leap

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For investors and governments eager to spot any sign of inflation as the global economy recovers from the coronavirus pandemic, Chinese factories are a good place to look.

The country this week released figures showing that the price of raw materials and goods leaving its factories rose 6.8 per cent year on year in April, its fastest pace of growth in more than three years.

For almost all of 2020, China’s producer price index was in negative territory as Covid-19 suppressed demand. The recent and sudden rise was partly driven by the comparison with a year earlier and, with consumer price rises still below 1 per cent, the overall inflation picture remained mixed.

But the data was nonetheless a sign of pockets of price increases emerging across China’s rapid recovery, where higher overall inflation is expected this year. It also reflected a global rally in commodity prices that has been supported by China’s voracious demand as well as hopes that other big economies will bounce back, too.

“A combination of China and external factors led to this PPI surge,” said Robin Xing, chief China economist at Morgan Stanley. “It’s like a perfect storm.”

Line chart of Producer Price index showing Producer prices in China rise at the fastest year-on-year pace since 2017

China’s PPI index is made up of prices of producer goods, such as wardrobes or washing machines, that factories sell to shops before they are sold on to consumers.

It also includes the prices of raw materials and commodities, such as coal, when they are sold from extraction companies to businesses that use them to make goods.

It was the latter that drove the recent surge in Chinese producer prices. Global commodity prices, which collapsed last year in the early stages of the pandemic, have since rebounded. Iron ore this week hit its highest level on record, while oil prices have recovered sharply from last year.

Xing estimated that 70 per cent of the April PPI increase was driven by commodities. That rally was also tied to China’s recovery, which has been backed by strong industrial growth and a construction boom that led to record output of steel last year.

As such, the data reflected both the pace of China’s recovery as well as a global commodity rally that it helped fuel and now extends beyond it.

For policymakers, one crucial question is whether higher producer prices will feed through to consumer prices. China’s consumer price index was just 0.9 per cent in April — its highest level in seven months, but far from a level that would generate immediate fears of broader inflation within China.

While economists expect a rise in CPI inflation in China this year, they suggested that any reaction from the People’s Bank of China to this week’s data was unlikely. The portion of the producer price index that represents the prices at which businesses buy consumer goods, as opposed to raw materials, was up only 0.3 per cent year on year.

Analysts at HSBC said transmission from PPI to CPI would be “limited”, allowing policymakers to remain “accommodative”.

Ting Lu, chief China economist at Nomura, forecast CPI inflation to rise to 2.8 per cent by the end of the year, with “pass-through” effects from PPI. But he suggested that the PBoC was unlikely to tighten in response to PPI, and that higher raw material prices instead posed a risk to Chinese demand and the wider recovery given controls on credit availability.

“For a typical borrower, $1bn six months ago may be enough to buy steel and cement to finish one project, but today it’s [maybe] not,” he said.

While the PBoC has not increased official rates since lowering them last year, the Chinese government has nonetheless tightened credit conditions over recent months.

It has also taken measures to rein in both its property sector, on concerns that easier money would encourage asset bubbles, and its steel sector, which has churned out the metal at a rate that threatens Beijing’s environmental commitments.

China’s gradual decarbonisation ambitions — and any production cuts they lead to within the country — are seen as constraints on supply, buoying the price of commodities further. 

Beyond raw materials, economists are closely watching other shortages. Iris Pang, chief economist for greater China at ING, said producer price inflation would be followed by chip inflation. A shortage of semiconductors, she said, was already beginning to drive price increases for consumer products such as washing machines and laptops.

Line chart of Per cent  showing Producer prices for consumer durables are gathering momentum this year

While the PPI index showed a much weaker increase in consumer goods than for raw materials, on a month-on-month basis there were notable rises. Durable consumer goods were up 0.4 per cent month on month in April, the fastest pace of growth since at least 2011, according to CEIC, a data company.

Apart from domestic construction, part of the demand for raw materials has been to drive the production of goods for export to western countries.

Data on Friday showed Chinese exports leapt 32.3 per cent year on year in April. But even when compared with April 2019, before the pandemic, the rise was about 16 per cent on an annualised basis, Morgan Stanley estimated.

Competition between producers in China meant this did not necessarily imply inflation for consumers overseas. Instead, China’s recent PPI jump hinted at just one of the global effects of western responses to the pandemic.

“If you try to figure out what is the end demand here for this PPI recovery, it is global stimulus,” said Xing. “External demand led to China’s export recovery, [and] now it’s far beyond its potential growth”.



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Analysis

Covid batters India’s aspiring middle classes

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When Ram Prakash died after a feverish and breathless week, his wife and 16-year-old daughter’s heartbreak was compounded by fear that the modest middle-class safety net he had knitted together might be ripped apart.

The 53-year-old, a tax adviser to local businesses, was one of the millions who had joined India’s fast-growing middle class in recent decades. Their rising incomes, better education and consumption powered one of the great global economic success stories.

But the calamitous second wave that claimed the life of Ram, the family’s breadwinner, has shattered the Prakashes’ hopes for the future. “Our life was going good but now it’s all over,” said Uma, his widow.

Economists warned that the latest outbreak could have long-term ramifications for middle-class Indians, whose rising consumption was expected to be the country’s growth engine for many years.

“India, at the end of the day, is a consumption story,” said Tanvee Gupta Jain, UBS chief India economist. “If you never recovered from the 2020 wave and then you go into the 2021 wave, then it’s a concern.”

India reported more than 320,000 Covid-19 infections and 3,800 deaths on Monday. Experts maintain that both figures are vastly undercounted.

The disease has heaped suffering on Indians irrespective of background. Yet this time, it has also hit hard an aspirational middle class whose newfound privilege previously helped shield them.

A lack of oxygen has been blamed for thousands of deaths © Sanjeev Verma/Hindustan Times via Getty

Public-health experts pointed to signs that after widespread infection among the urban poor last year, sectors of society including the comparatively affluent were more vulnerable this time round. This was compounded by the near-collapse of private health services on which they relied.

“You’re affluent but you can’t get a hospital bed. You’re affluent but you can’t get oxygen,” said Saurabh Mukherjea, founder of Marcellus Investment Managers. “That’s deeply disorientating.”

India’s middle class was already severely weakened by the recession that followed last year’s lockdown, even if they were better protected from the virus.

The Pew Research Center found that 32m people fell out of India’s middle class — defined as those earning between $10 and $20 a day — in 2020. That represented more than half of those added to the category since 2011.

Bar chart of Estimated change in number of people in each income tier due to the global recession (m) showing India’s poor grew while middle class shrank in 2020

India’s economy was expected to roar back before the second wave struck. For middle-class Indians on the brink, such as the Prakash family, this second shock may prove too much.

Ram, the tax consultant, had moved his family to a one-bedroom house in a humble New Delhi neighbourhood, bought a car and sent his daughter to a low-cost private school, hoping she could become a chartered accountant.

“He gave us so much when he was alive,” said Vasundhara, his daughter. “I only hope I will be able to continue my studies.”

Experts have debated what drove the high caseloads among middle class and rich Indians during the second wave.

Anup Malani, a professor at the University of Chicago, suggested that those populations proved more susceptible, especially as new variants spread.

In Mumbai, for example, studies last year found that about 50 per cent of slum residents had Covid-19 antibodies, compared with less than 20 per cent in more affluent surrounding neighbourhoods.

This is believed to have left the middle and upper classes more vulnerable, particularly to severe disease, researchers said. Doctors have reported similar trends elsewhere in India.

“The first wave largely infected poorer populations,” Malani and two co-authors wrote this month. The second wave “is disproportionately composed of individuals who are from non-slums”.

Bar chart of Estimated number of people in each income tier in 2020 before and after the global recession (m) showing The pandemic sets back growth of India’s middle class

Researchers said more data were needed but other susceptible populations could include those outside cities, such as in poor rural areas with shoddy healthcare where the virus was wreaking havoc.

The outbreak was so sudden that it overwhelmed even India’s best hospitals, including private facilities in cities such as Delhi or Bangalore.

Fewer than 1 per cent of Delhi’s 5,800 Covid-19 ICU beds are available, while crippling shortages of oxygen have contributed to countless deaths.

After Ram Prakash’s oxygen levels dropped, his family spent two frantic days ferrying him to six separate hospitals — both private and public — in a desperate bid to find treatment.

In the end, they brought him home. Ram died on April 27.

Uma and Vasundhara fear economic ruin. They have a shortfall of Rs30,000 ($408) to meet immediate expenses, including school fees and the mortgage on a neighbouring unit that Ram bought as an office.

“Right now our worry is just to survive, to get food and meet our daily expenses. But there won’t be enough,” said Vasundhara.

They plan to sell their car and Uma, a former Sanskrit teacher, wants to find work again. But they worry hopes of a better life are over.

“We had never imagined this could happen to us,” Vasundhara said. “We just can’t get our head around this.”



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Reeves promotion underlines Labour shift to centre ground under Starmer

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When Sir Keir Starmer promoted Rachel Reeves to shadow chancellor late on Sunday night it emphasised his determination to defy the left of the Labour party and move in a more “centrist” direction after a series of disappointing local election results.

Reeves is unpopular with many “Corbynista” members — supporters of the party’s former hard left leader Jeremy Corbyn — because of comments she made in 2013 when she was shadow work and pensions secretary. That controversial moment saw her promise to be “tougher” than the ruling Tories on benefit costs.

Her role as vice-chair of Labour Friends of Israel is also contentious among many Corbyn supporters who oppose the actions of the Israeli government. And while other MPs agreed to serve on the Labour front bench under the Corbyn leadership in 2015, Reeves was one of a handful who refused to do so.

Starmer first considered making Reeves shadow chancellor when he became leader in April last year — only to drop the idea, fearing that it would prompt a backlash from left-wingers.

Yet it would be wrong to characterise the 42-year-old MP for Leeds West — a former junior chess champion — as a “Blairite” or “rightwinger” even in Labour terms.

Sir Keir Starmer promoted Rachel Reeves in a reshuffle of his front bench on Sunday © Stefan Rosseau/PA

During the last parliament she chaired the business select committee, a position she used to interrogate corporate failure by Carillion, the collapsed contractor. She meanwhile struck out as a writer, penning two books about female MPs.

In 2018, she used a speech in London’s East End to call for a new series of wealth taxes to raise more than £20bn a year — shifting the fiscal system from income to property. The then shadow chancellor John McDonnell resisted the idea, amid concerns over a backlash from middle class Labour voters.

Indeed, there was a moment in 2019 when some of Corbyn’s aides — including policy adviser Andrew Fisher — advocated bringing Reeves into the shadow cabinet.

Sharper edge but no shift in strategy

In the short-term her promotion to one of the most important roles in the shadow cabinet may give a sharper edge to Labour’s top team but not necessarily bring a shift in strategy.

That is because the party creates its election manifestos through a drawn-out process called the “national policy forum” over several years.

Starmer has eschewed creating new policies on the hoof in favour of a focus on rebranding, telling voters Labour is “under new management” after the electorally disastrous Corbyn, who lost two general elections in 2017 and 2019 — the latter by the biggest margin in nearly a century.

The opposition leader’s popularity rose last year as he forensically attacked the ruling Conservative government over pandemic failures. But with the Tories enjoying a bounce from the vaccine rollout, he was criticised during the local elections for a lack of a positive policy vision. Some Labour insiders blame that for the setback at the polls — in which the party lost 326 council seats and was defeated in the Hartlepool by-election.

On Monday, many colleagues were positive about the promotion of Reeves after a year in which she has been one of the most high-profile figures on the front bench.

As shadow Cabinet Office minister, she took the fight to the Conservative government over its spending on personal protective equipment — expressing anger at the many contracts given to Tory contacts. She has also kept up the pressure on the Conservatives over the Greensill scandal.

Colleagues said as shadow chancellor she will emphasise the need for Labour to show it can be trusted to run the economy — an area of traditional political weakness for the party.

‘Competent and sensible on the economy’

That would continue the theme set by Dodds, who said in a speech in January — using the word “responsible” 23 times — that Labour would offer “responsible economic, fiscal and monetary policy”. The Starmer team has already distanced itself entirely from Corbyn’s 2019 election manifesto, with £83bn of annual public spending increases.

In an interview with the Financial Times last year Reeves struck a similar tone, saying the party needed to be “competent and sensible” on economic matters.

Yet she is not expected to return the party to the “austerity lite” approach of Ed Balls, shadow chancellor under former leader Ed Miliband, who promised not to increase borrowing even for capital expenditure.

One ally said Reeves could be expected to draw up a “transformative” programme — involving changes to the tax system and the decarbonisation of the economy — while also reassuring the public that Labour would spend people’s taxes wisely.

The decision to shift Angela Rayner, deputy leader, from her job as party chair plunged the reshuffle into chaos at the weekend © Jacob King/PA

Starmer’s reshuffle at the weekend was thrown into chaos after allies of Angela Rayner, the deputy leader, leaked she was being demoted from her job as party chair after the local election failures. The ensuing political storm overshadowed some more positive electoral results on Saturday in cities such as Manchester, London and Bristol.

Rayner turned down the job of shadow health secretary and instead took Reeves’s old job as shadow Cabinet Office minister as well as “shadow secretary of state for the future of work”.

Deep discontent

On Monday, after a two-hour shadow cabinet meeting, Starmer was seen buying a coffee at Westminster with Rayner in an attempt to put on a public show of unity after a weekend of acrimony.

Starmer’s bungled reshuffle has sown deep discontent among senior Labour MPs. “You can’t understand how angry people are,” said one. Allies of Rayner said she felt a “deep sense of betrayal”.

The reshuffle saw Dodds move to party chair and Alan Campbell promoted to chief whip with the departure of 70-year-old Nick Brown.

Lisa Nandy, shadow foreign secretary and MP for Wigan, told colleagues she was convinced Starmer was planning to sack her and it was only a rearguard action by her supporters that persuaded him to drop the plan.

Nandy warned Starmer that she would quit the Labour front bench, rather than be demoted to another role.

Referring to the plans to demote first Rayner and then Nandy, one Labour MP said: “What genius would think it a good idea to demote not one but two women representing northern seats?”

 



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