CM-AM Inflation - Interview with Arnaud Grimoult, Fund Manager at Crédit Mutuel Asset Management

Where are we on 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. 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.
Looking at the latest statistics, total inflation in the euro area accelerated again sharply in October to reach 10.6% year on year while core inflation (i.e. excluding energy and food) also strengthened to 5.0%. These inflation figures far exceeded consensus forecasts and expectations that inflation would have exceeded its peak in September. The breakdown shows that once again all the main components contributed to the acceleration of inflation in October, particularly on core inflation.
Looking at the details, for the energy component, despite the improving market environment (wholesale gas and electricity prices have fallen sharply from their highs at the end of August), the impact of lower wholesale energy prices on consumer prices continues to be country specific (i.e. dependent on local market structure, pricing practices and interventions by national governments) and will take time. For example, additional price blocking measures have been announced in Germany but will only come into force early next year. On the other hand, the lull observed in energy prices is not expected to last with the winter and the room for maneuver of the European states to consume will be significantly reduced due to the cessation of deliveries of Russian gas. Food inflation remains robust and reflects the rapid impact of high producer price inflation on consumer prices. We believe that the current momentum could continue for several months as consumer prices continue to catch up with high production costs and the supply of fertilizers remains limited. In industrial goods, we note the beginning of a slowdown in prices with, in particular, European business surveys (PMI, IFO, EC) which reported a significant easing of pressure on input and output prices compared to the peaks of mid-2022, as consumer demand slows, supply chain conditions normalize and corporate pricing power decreases.
Finally, in services, inflation is expected to remain high mainly via the salary component. We continue to rule out a runaway scenario with a wage price loop, although some catch up in wage levels seems likely at the end of 2022 and in 2023. The latest rounds of collective bargaining in Germany confirm this wage trend and show no second round effects with permanent increases of 3.25% in 2023 and 2024, in line with the growth that could have been achieved before Covid-19 in addition to two single payments of euros1500. Negotiations are now expected in sectors whose production costs are less affected by the energy crisis (civil service, engineering, services, etc.) And which could lead to higher amounts.
In terms of inflation expectations in the market, fears about the pace of monetary tightening by central banks and the risk of recession led to a correction of breakeven points of around 50 bp at the beginning of the year. The latest surprises on the publication of inflation figures in the Eurozone and the rise in inflation uncertainties in 2023 have led to a further appreciation of breakeven points in the order of 25 bp in recent weeks to be around 2.25% on a German 10 year maturity, for example. It is in particular the energy supply for next winter (2023-2024) and a potential catch up in utility prices when purchasing power support measures stop that potentially create upside surprises on inflation in 2023.

What about the US?

In the United States, inflation has also continued to surprise in recent months but its slowdown has already begun unlike Europe. Indeed, the Consumer Price Index (CPI) is moving more and more away from its June peak of 9.5% with a year on year low since January 2022 at 7.7% year on year on the latest figures for October (8.2% in September). Nevertheless, we believe that the slowdown will be very slow and will require several quarters.
If we look at the data for October in detail, we see that the slowdown in prices is now broadly widespread. Energy prices were up slightly from one month to the next (mainly due to the recent rise in oil prices following the reduction in OPEC quotas) but continue to weigh negatively on total inflation, a trend that has already been well established since June with gasoline prices falling by more than 25% since June. On the food side, prices are still on the rise but the pace was at the lowest since August 2021. Risks to food inflation, however, remain on the upside due to the uncertain outlook for key inputs, including agricultural and energy products, as well as the impact of wage increases on an already tight labor market in this sector.
Regarding core inflation, and this is a new trend, we see that after uninterrupted months of increases, it begins to slow down to 6.3% on a year on year basis for the month of October after its 40 year high reached in September at 6.6%. However, its high level reflects the broad 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 and improved logistics as a whole) and the sharp slowdown in demand. One example is the sharp fall in used car prices for the fourth consecutive month, when this component had exploded in 2021 and early 2022. This is also the case for furniture (4% of the total basket), which recorded their first decline since the beginning of 2021. The continued decline will require further improvements in supply chain tensions. Non real estate services also did not grow at a monthly rate, the first since December 2021, in line with low healthcare prices (a trend that should not last) and a slowdown in wage pressures in recent months. 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. Over time, the housing market correction is expected to affect the rents and imputed rents taken into account in the index. However, this adjustment will take several months, as it is an indicator delayed by about 9-12 months due to many construction and methodology biases. Finally, the rise in the rental component could even paradoxically continue because of the rise in rates for the purchase of housing, which increases the pressure on rents.

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 medium term inflation should return to levels more in line with central bank targets but higher than those seen in the last decade for several reasons. 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 cost of the ecological transition, where tens of thousands of billions will have to be invested to develop energy sources and cleaner production, will be partly financed by higher energy prices. 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 labor in some industries, again with inflationary consequences.
Finally, in the Eurozone, the ECB is considering incorporating more housing related costs into the Eurozone inflation calculation basket, as is already done in the United States.
In this sense, the IMF showed in a study published in October that core inflation has become more ‘backwarded looking’ and that the impact of global commodity prices on domestic inflation has increased after the pandemic, will last longer and will cause inflation rates to land at higher levels than we have seen in the past.

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, invested 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 realized 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.