Don’t get caught up in the inflation debate

Inflation isn’t friendly to bondholders, and the potential for it to surge during the post-pandemic recovery is cause for concern to many investors. But that concern may be largely misplaced.

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Pandemic-related trends such as working from home can help fuel productivity, and “higher productivity generally means lower inflation,” said Patrick O’Toole, vice-president of global fixed income with CIBC Asset Management, in an interview in late June.

“That’d be supportive for lower bond yields going forward.”

However, O’Toole was less interested in forecasting whether pandemic trends will persist and more interested in focusing on trends that have proven stable.

“Long-run secular forces haven’t gone away,” he said, citing debt, demographics and disinflation. Those three Ds are primarily why GDP and inflation stayed at or below 2% in the last cycle, he said.

“They’re what drive the medium- to longer-term outlook that investors should stay focused on,” O’Toole said.

More specifically, governments took on huge debt to fund pandemic spending, resulting in “a sugar high of growth” that won’t last as pandemic programs wind down, he said.

“The high fades away as we move into 2022,” O’Toole said. “That sets the stage for bond yields to potentially be lower by year-end, even as investors price in this eventual outcome.”

Demographics and disinflation refer, respectively, to populations skewing older (seniors consume relatively less) and the ongoing acceleration of technological development (which disrupts traditional business models, keeping prices down).

“Those three Ds mean that the trend of 2% growth and inflation will return,” O’Toole said. “That’s what we saw in the post–great financial crisis era until the Covid era.”

As a result, government bond yields will likely trend lower, he said. Last week, U.S. yields fell as expectations for inflation began to temper, though they’ve since rebounded.

In the short term, yields may rise if inflation doesn’t prove transitory as central banks expect, O’Toole acknowledged.

He also said he expected real yields to move a bit lower. “Real-return bond yields generally follow nominal bond yields,” he said.

The two diverge when inflation expectations shift, but “generally, that adjustment is usually fairly brief.”

Further, “some would argue that central banks actually want negative real yields to continue, thereby making it easier to service debt.”

Like the central banks, O’Toole expects that increases in inflation as the economy reopens will be transitory. Commodity prices have already fallen from their highs, he said, and the Atlanta Fed’s wage growth tracker, which monitors the wages of the same group of workers over a 12-month period, is at its lowest levels since 2018.

And while the pandemic resulted in some businesses onshoring their operations, “globalization certainly isn’t dead,” O’Toole said. “Global trade volumes are at fresh new highs.”

He also noted that, while the U.S. and Canada are experiencing inflation above central bank targets, inflation globally is near historical lows.

U.S. annual inflation hit 5.4% in June, and Canada’s inflation rate in May was 3.6% — the largest yearly increases since, respectively, August 2008 and May 2011. (Canada’s June reading will be released later this month.)

“We think inflation will be back at 2% in one year in the U.S., and Canada will stay close to 2% for the next year too,” O’Toole said.

On Wednesday, the Bank of Canada releases its quarterly monetary policy report, and will likely upgrade its inflation forecast to make room for higher oil prices, said Avery Shenfeld, CIBC’s chief economist, in a weekly economics report. However, the central bank’s previous inflation projection of about 2% for 2022 probably won’t change much to avoid rattling markets, he suggested, and will be based in part on labour market slack.

The Federal Reserve publishes its next summary of economic projections, including inflation, in September.

O’Toole’s advice for investors was to avoid getting caught up in short-term trends.

“Stay balanced,” he said. “We always get curve balls like last year, and bonds continue to do their job when that happens. Nothing has really changed for the longer term.”

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