In Europe, core inflation has not exceeded 2% in nearly two decades. Levels have been similar in the US during the same period, only occasionally approaching 3%. Therefore, inflation has remained contained for 20 years… until now.
Recently, headline inflation has experienced a rebound (reaching 4.1% in Germany, 4% in Spain, and 5.3% in the US), due to a rise in energy costs caused by soaring oil and gas prices, among other factors. If we look at core inflation, which excludes food and energy, we see that it remains moderate in Europe (1.9%) and Spain (1%).
In this environment, the market has called the transitory nature of inflation into question, which the central banks continue to defend, while most analysts have revised their inflation forecasts upward.
At EDM, we do not know what inflation will do in the future, but we maintain that the fund’s current positioning is the most appropriate for an expected scenario of moderate inflation.
Interest rates, meanwhile, have trended downward over the last 20 years, along the entire curve and on both sides of the Atlantic. There have been temporary rallies, for example in Spanish rates during the sovereign crisis of 2012, but in general these have remained limited due to an absence of relevant inflationary expectations. An examination by segment reveals that, for instance, 1-year monetary rates in Europe went from 4.5% to -0.60% in the period, and that 10-year rates of 5% fell barely 0% (even less in many European countries).
With the persistent downward trend in interest rates and inflation oscillating between relatively stable ranges, real rates have fallen and remained in negative territory for years. In Europe, for example, the 10-year real interest rate has been negative since 2014.
Some central banks, meanwhile, will begin shifting their approach toward a less lax monetary policy if prices, growth, and employment data confirm their forecasts in the coming months. The Fed is expected to begin tapering in the last quarter of 2021 and the first rate hikes are slated for the end of next year. In Europe, however, hikes are not expected so soon.
One risk we face is that the upturn in inflation will persist longer than anticipated in an environment of very low, often negative, interest rates.
Moreover, the valuations of one of the traditional fixed-income alternatives—corporate credit bonds—are not “cheap” at the moment. Sovereign rates have dragged credit yields down and, the fact that the majority of sovereign debt and high-quality bonds offer negative returns causes sovereign-credit yield spreads to narrow (even for lower credit categories).
EDM Ahorro, this year’s leader in its fund category, maintains a low portfolio duration given the risk of rising rates, the impact of which has already been observed this year. In sovereign debt, we maintain only inflation-linked bonds. In corporate credit, we have slightly reduced exposure to investment-grade credit, which often offers zero or negative returns on maturity and carries a high duration risk (that we do not want to assume) without remunerating the credit risk. The latest additions in investment-grade corporate bonds are issues in currencies other than euros with high credit quality and low durations, whose yields—after hedging the currency—are attractive relative to euro-denominated comparables. We maintain positions in high-yield corporate bonds and small- and mid-cap companies after applying strict selection criteria. In this respect, considerable effort is dedicated to analysing new bond incorporations and monitoring the companies in this segment. Finally, we increased exposure to the money market through the diversification of promissory notes, which offer positive returns and provide stability to funds during periods of interest rate corrections.
We believe the make-up of the fund, with a mix of different strategies, is fitting, considering the current environment.
Now that concerns about inflationary pressures have returned, it is important to remember that in its 34-year history, EDM Ahorro has vastly outperformed inflation (cumulative performance +345% vs. +165% for inflation). In our view, the fund is well poised to face the new challenges of the macro environment and should continue to deliver attractive results relative to the market, with contained volatility.
Fixed Income Fund Manager