Interview with Arnaud Grimoult, manager of the CM AM Inflation fund at Crédit Mutuel Asset Management.

What about inflation in the eurozone?

After a decade marked by the absence of inflationary risks, we have been experiencing a sharp acceleration in inflation for more than two years, which seems to have peaked. The Covid crisis had first dealt a blow to this situation by creating strong demand when the economy reopened. The war in Ukraine caused a major inflationary shock that was added to the previous one, which was linked to the end of the health crisis.
If we look at the latest figures, we can think that inflation (HICP) in the euro zone seems to have reached its peak in October 2022 at 10.6% since the data for December showed a further deceleration stronger than expected at 9.2% over one year after 10.1% in November. Energy prices remain the main driver of higher prices, but their surge slowed sharply to 25.7% year on year from 34.9% in November, and explains almost all of the fall in inflation from one month to the next. This decline is due in particular to government aid measures that are not likely to last, which could lead to a further rise in inflation in January or after the cessation of the energy shields that have been extended for the first half of the year. December also includes a technical element with the decision of the German government to reimburse household gas and heating bills. Finally, the recent abnormally high temperatures have allowed European countries to reduce their energy consumption and draw little on strategic reserves, thereby fuelling the relapse in gas and electricity prices since this summer. Nevertheless, this lull is not expected to last with the winter, the near cessation of Russian gas deliveries and the European embargo on Russian oil that is being put in place.
Conversely, the rise in food prices accelerated again to 13.8% year on year (after 13.6% in November), as did core inflation (i.e. excluding energy and food), which continues to accelerate to 5.2% year on year (against 5% in November) in contrast to the trend on total inflation and which confirms the broad and profound diffusion of inflationary pressures to all parts of the economy.
In industrial goods, a slowdown in prices (+6.4% year on year) continues in line with the supply deficit, which continues to moderate as consumer demand slows down and the improvement in production chains continues, but to a lesser extent than in the United States, while the much stronger rise in production costs (linked to energy) has been able to be today only very partially passed on to selling prices.
In services, prices are still rising (+4.4% year on year after +4.2%), but more in line with very high demand (while consumption has shifted from goods to services with the reopening of economies and the pass through of energy prices) than with rising wages (around +3%). Service inflation is expected to remain high mainly through the wage component with wage increases that will continue to gain momentum and whose duration will depend on the availability of labor and the extent of the recession. However, we continue to rule out a runaway scenario with a wage price loop, although some catch up in wage levels seems likely in 2023.
In terms of inflation expectations in the market, fears about the pace of monetary tightening and the strength of central bankers' rhetoric in their fight against the risk of disinking inflation expectations have led to a correction of breakeven points of around twenty bp since the beginning of the year, slightly above 2%. We believe the market is too convinced that central banks will be able to slow inflation in the coming months. Inflation is expected to reach 2.7% in October, while we are still at 9%. Nor should the reopening of China be neglected by boosting consumption in all sectors, including energy, and further fuelling inflationary pressures.

What about the US?

In the United States, the consumer price index (CPI) is moving further away from its June peak of 9.5% with a year on year low since October 2021 and down for the sixth consecutive month to 6.5% for the month of December after 7.1% in November and 7.7% in October. Nevertheless, we believe that the slowdown will be very slow and will require several quarters.
Looking at the data for December in detail, we see that the slowdown in prices is now broadly widespread. Food inflation was only 0.3% month on month, the lowest rate since March 2021, while energy inflation was still down 4.5% month on month in line with the recent drop in oil prices.
Regarding core inflation, and this is a big difference with the euro zone, we see that after uninterrupted months of increases, it confirms the beginning of a slowdown to 5.7% in December after 6.0% in November, 6.3% in October and 6.6% in September at the highest over the last 40 years. Its still very high level, however, reflects the wide spread and persistence of inflationary pressures in the US economy.
In durable goods, prices continued to slow in line with the improvement in supply (rapidly falling maritime freight prices, logistical improvement, increase in inventories held by distributors) and the sharp slowdown in demand. In particular, there was a notable drop in the prices of used cars for the fifth consecutive month, when this component had exploded in 2021 and early 2022. This is also the case for the price of new cars.
Non residential services inflation remains high, although it seems to have stabilised somewhat with a very slight increase from one month to the next (0.18% vs. 0.22% in November). The Fed believes that its development in the coming months will be highly dependent on that of wages and will be the most representative element of the tensions in the labor market. However, recent indicators (average hourly wage in the employment report, Atlanta Fed indicator) have already suggested a moderation of wage pressures.
Only the ‘housing, rent’ (shelter) component, which accounts for 33% of the CPI index, and for more than 40% of core inflation, remains very dynamic with levels of increases not seen in 40 years and continues to fuel core inflation strongly for months. We continue to see gains from one month to the next between 0.6% and 0.8% (0.58% for December and November).
Over time, the housing market correction is expected to affect the rents and imputed rents taken into account in the index. But this adjustment will take several months as it is a delayed indicator of about 9-12 months due to many construction and methodology biases.

What is your analysis of inflationary trends beyond the coming quarters?

In addition to the cyclical trends just mentioned, we are also witnessing a partial reversal of the structural trends that helped to limit inflation in the last decade.
Thus, we believe that inflation over the medium term should return to levels more in line with central bank targets but higher than those seen in the last decade. Several events we are witnessing argue for continued high inflation. First, the pandemic crisis and then the conflict in Ukraine exacerbated the weaknesses of the hyper globalized model adopted by developed countries. These shocks have led to profound changes in the organisation of the world's economies, with numerous relocation movements that should help fuel inflation on both sides of the Atlantic. This dynamic is reinforced by the recent willingness of European states to strengthen their military defense and independence in strategic sectors (energy, food, technology) with a sharp acceleration of public spending in these areas.
On the other hand, the increase in tax expenditure, particularly to finance the cost of the ecological transition to develop energy sources and cleaner production, is expected to be massive and will affect all countries. For example, the European Union recently announced its intention to significantly accelerate the schedule of investments in renewable energy and liquefied natural gas terminals to reduce its energy dependence on Russia. It will also generate higher demand for certain metals (cobalt, lithium, nickel, etc.) And a lack of additional labour in some industries, again with inflationary consequences.
Finally, in the eurozone, the ECB is considering incorporating more housing related costs into the inflation calculation basket, as is already done in the United States.

Could you explain how to protect against this inflationary risk, which will therefore continue to remain massively present in the coming quarters and in the medium term?

In order to protect against inflation, which erodes the value of debt over time, inflation linked bonds can provide protection against rising prices directly integrated into the product. Unlike a traditional or ‘nominal’ bond, the coupon and redemption price that will be paid to the holder are not known at the time of purchase because they are directly indexed to a consumer price index, that is to say to the level of inflation observed in an economic area over a given period. Thus, the investor is guaranteed to have the same purchasing power at maturity as at the time of purchase of the bond.

Could you explain to us how the CM AM Inflation fund achieves this goal?

The CM AM Inflation fund, which invests mainly in eurozone inflation linked bonds, both protects itself against a rise in observed inflation rates and takes advantage of rising inflation expectations while taking a moderate exposure to rates (thanks to reduced modified duration).
The specificity of this fund launched in 2012 lies in its positioning on relatively intermediate maturities, between one and ten years, its average maturity being around five years. We believe that in the current market configuration this particular positioning of the portfolio allows it to make the best possible use of the indexed asset class.
Indeed, as the rise in inflation expectations reflects on all maturities, the fund can thus fully benefit from their rise while taking a moderate exposure to interest rate risk, which is particularly increased in the rising rate environment that is emerging for the coming months. In addition, exposure to intermediate maturities allows the fund to benefit more quickly from rising inflation, as the shorter the maturities, the more inflation indexed react to published inflation figures and changes in energy prices (mainly the price of oil). In the case of inflation linked bonds, it is very important to distinguish between long term and short term index linked bonds. The formulas give more weight to the fixed income component in long term bonds while the realised inflation component is predominant on intermediate bonds. Finally, bonds indexed to 10 year maturities and beyond are much more affected by the restrictive speeches of central banks seeking to avoid falling expectations of inflations on long maturities.