The vast majority of institutional bond investors have concentrated portfolios in nominal bonds. However, knowingly or unknowingly, all nominal bond investors are making an investment decision on inflation for the duration of the bond. Inflation has consistently dropped over the past 30 years and has given nominal bond investors little reason to re-evaluate their passive (or active) bet on inflation. Increasingly I hear “inflation is not a problem so why should I be concerned?” The more important question to ask is, “where do you think inflation is heading versus what’s priced into the market right now”? Inflation can be low but still underpriced by the market over the longer term, thus offering value.
Generically speaking, spreads are tight, rates are low, and good value in fixed income markets is tough to come by. At present, breakeven levels of inflation* are quite low when compared against most investors’ expectations and recent history.
Five Year Breakeven Rate of Inflation
In recent years, inflation linked bonds and inflation derivatives have gained liquidity and entered the mainstream. Investors would be wise to recognize the separate sources of interest rate risk and attempt to actively manage the real interest rate risk as well as the risks associated with increasing inflation. If inflation returns, investors in high quality fixed income stand to see their returns deteriorate. Meanwhile, low expectations for future inflation create an attractive long term entry point for investors seeking protection.
*Inflation breakeven in bonds is approximated as the rate of inflation that would make the nominal return of an inflation-linked bond equivalent to that of a conventional fixed rate nominal bond with the same maturity. This breakeven rate is typically approximated as the spread between the quoted nominal yield of a conventional bond and the quoted real yield of an inflation-linked bond.
Following a warlike campaign that had three different leading candidates in less than two months (causing skyrocketing volatility in Brazilian assets), the result was the re-election of Dilma Rousseff by a small margin. Clearly full employment (the unemployment rate is at historical low level of 4.9% compared to almost 13% in 2003) and the increase of social programs were the key canvassers supporting the incumbent.
On the economic front, despite full employment, continuity is not really auspicious for Brazil. In fact, the country is facing stagflation (growth close to zero and above-target inflation – see top chart), unbalanced macro policy mix (large fiscal and quasi fiscal deterioration amid tight monetary policy – bottom chart), widening external deficits, clear bottlenecks on infrastructure, and no reform agenda. Ah, not to mention the increasing odds of energy rationing if the rainy season, that is starting now, disappoints. This means that “more of the same” policies on the economic front will likely result in a steady rise in unemployment rate next year.
The challenges ahead are not really much different from one or two years ago, but the degrees of freedom for policy makers are diminishing. A key difficulty (that is true for Brazil but also for most commodity exporters) is the deterioration of terms of trade (ratio between export and import prices) and loss of competitiveness. Initially this was hidden by abundant liquidity and capital flows but is increasingly worrisome. Many observers saw the strong performance of Brazil following the 2008 crisis as something related to pure domestic factors, but the truth is that terms of trade of Brazil increased substantially between 2008 and 2010 increasing the leeway for countercyclical policy. After 2011, terms of trade started to deteriorate (in sync with commodity prices) but the policy response was again the same (more stimulus – even if the problem was different). While large fiscal and quasi fiscal stimulus was good enough to sustain consumption, wages and employment for some time, it has been showing many side effects: i) loss of competitiveness (as unit labor cost surged in USD terms) with consequent production stagnation and widening external deficits; ii)excessive burden on monetary policy (to offset fiscal looseness); iii) loss of business confidence and no investment growth (as government intervention increased uncertainty and interest rates moved higher); iv) higher inflation expectations and pent up demand for higher administered prices (since freezing administered prices hurt the corporate sector and increased the perception that inflation will be higher in the future).
There is no easy way out. Social demands are high but so is inflation and public expenditures. The administration does not have the same degrees of freedom to attend to irreconcilable demands. Doing more of the same will simply increase the probability of Brazil losing its investment grade status in the medium-term. It is crucial to regain business confidence with a sound macro policy (where fiscal and inflation targets are met) and a minimum reform agenda that addresses the competitiveness issues (tax reform, labor reform, etc). In the short-term markets will wait for the announcement of a new economic team (starting with a new Finance Minister), expecting a positive agenda that could boost business confidence and attract private capital on key investment projects.
The competitiveness issue will limit Brazilian Real (BRL) appreciation for some time, keeping investors cautious of taking FX risk (particularly in an environment in which commodity prices are not increasing). On the other hand, real interest rates in Brazil remain abnormally high for a global economy recovering gradually and with near zero interest rate in developed markets. This means that if reasonable economic policy is implemented (reducing the odds of ratings downgrades), it is unlikely that BRL depreciation will surpass what is implied by FX forwards and solvency will remain sound. This should continue to attract fixed income investors to both local market and hard currency debt in Brazil.