Interview with Arnaud Grimoult, Fund Manager at Crédit Mutuel Asset Management.

Photo Arnaud Grimoult
Arnaud Grimoult

Since the end of summer 2021, the eurozone has seen a sharp rise in inflation rates. Could you tell us more?
Since the beginning of the year, we have witnessed a sharp rise on both sides of the Atlantic, both in inflation figures published by statistical bodies and in inflation forecasts observed on the markets. This spike in inflation was first fueled primarily by the reopening of economies after the pandemic shock and subsequent extended periods of closures. Other factors, such as higher commodity prices, disruptions in certain supply chains and supply imbalances that failed to meet demand in some industries such as services, were also added. The latest inflation figures published in the eurozone for October showed that inflation continued to accelerate, reaching 4.1% year on year in October, after rising 3.4% in September, its highest level since July 2008. This increase is largely driven by energy, whose prices rose by 23.5% compared to October 2020, after a rise of 17.6% in September. The core consumer price index, which excludes energy and food, rose 2.1% year on year in October, after rising 1.7% in the previous month.
This is the same dynamic that can be observed in the United States, where US inflation figures reached the highest level recorded since the early 1990's. Thus, in the last reading for September, total inflation reached 5.4% over one year while core inflation stood at 4.0% over one year.
In terms of inflation forecasts, we witnessed the same movements, with a return to levels that had not been seen since 2011. Thus, the anticipated level of inflation that can be read in German 10 year bonds, which had experienced a retracement in the summer of 2021, experienced a very sharp rise, reaching almost the key level of 2% at the end of October, before correcting by around twenty basis points following the statements by Lagarde that are considered less accommodative by market participants. The same movement was observed on the US side, with an expected level of inflation in 10 year US bonds, which rose up to almost 2.70% before undergoing a similar correction.

Central banks talk of 'transitory' inflation peaks. What do you think?
Central banks continue to favour an optimistic scenario where demand growth will soon normalise while the productive apparatus will recover to meet demand in an environment where wage increases are limited to specific sectors rather than generalizing. This scenario allows them to maintain very accommodative monetary policies with very low interest rates, which maintains favourable financing conditions for governments and companies.
It should be noted, however, that there are risks that rising inflation may take longer to normalise.
First, central banks' recent strategic reviews have led them to adapt the inflation targets of their monetary policies. In the United States, the US Federal Reserve (FED) has adopted since summer 2020 a flexible average inflation target of 2% known as FAIT (Flexible Average Inflation Targeting), valued over time, according to the labour market. The EDF can therefore tolerate an overshoot in the level of inflation if labour market conditions remain far from the optimal level of employment, which is still the case at present. In the eurozone, the ECB also announced in summer 2021 a new monetary policy strategy, setting an explicit symmetrical inflation target of 2%. On the other hand, the ECB is considering incorporating more housing related costs into the calculation of eurozone inflation, which will push inflation indices higher.
Second, on the energy side (oil, gas, electricity), in addition to the shock linked to economic recovery and fears of shortages, the rise in energy prices, at least in Europe, is also linked to underinvestment in gas production. Europe's supply of other energy sources is also likely to be insufficient, compared with growing needs, in a context of ecological transition that is holding back and making the development of new production capacity more expensive (ecological taxation, as in Germany, carbon reduction targets). However, persistent pressures on energy prices could keep inflation high for an extended period of time.
In addition to the high energy inflation we are currently experiencing, supply shortages in some sectors are also causing price increases. This is particularly the case with semiconductor supplies, which force companies to limit production volumes in many industries such as the automotive and technology sectors. Some sectors are even affected by labour shortages that force them to consent to wage increases, fueling inflationary pressures. Many supply chains are still very disrupted, with shortages of ships and containers available, causing a very sharp rise in shipping freight prices. All of these cost increases will ultimately feed through to consumer prices, within a certain period of time, that is the so called 'second round 'effects. And they can keep consumer prices rising for an extended period.
We note that many companies announced during the Q3 2021 earnings season on the rise in their production costs as well as on their ability to pass price increases to the end customer, which supports the scenario of inflation that would last longer than expected.
We are also monitoring year end wage negotiations after increases in minimum wages in France and Germany that could help support inflation. At this point, however, we are excluding a price earnings loop scenario that would lead to an inflationary slippage as unemployment remains at elevated levels in Europe.

How can we hedge against this inflation risk?
In order to protect against inflation which erodes the value of debts over time, inflation linked bonds can provide protection against price increases that are directly embedded in the product. Indeed, unlike a traditional or 'nominal' bond, the coupon and redemption price that will be paid to the holder is unknown at the time of purchase because they are directly indexed to a consumer price index, i.e. the level of inflation observed in an economic area over a given period of time. Thus, the investor is guaranteed to have the same purchasing power at maturity as at the time he bought the bond.

Could you explain to us how the CM AM Inflation Fund achieves this objective?
The CM AM Inflation fund, invested primarily in inflation linked bonds in the eurozone, offers both the ability to protect itself against a rise in observed inflation rates and to take advantage of rising inflation expectations while taking moderate exposure to rates (thanks to reduced sensitivity).
The specific feature of this fund, launched in 2012, is its positioning on relatively intermediate maturities of between one and ten years, with an average maturity of around five years.
As the rise in inflation expectations is reflected across all maturities, the fund can therefore take full advantage of their rise while taking a moderate exposure to rate risk. Thanks to this specific positioning, the fund can also quickly benefit from rising inflation, as the shorter maturities, the more inflation linked bonds react to published inflation figures and to changes in energy prices (mainly the oil price). Among inflation linked bonds, it is indeed very important to distinguish between long term ILBs and short term ILBs. The indexation formulas for these bonds give more weight to the rate component in long term bonds while the realised inflation component is predominant on short term bonds. Thus, short maturities offer a better instrument to protect against inflationary shocks, which we are experiencing.

What is the fund's investment process?
The tarting point for the construction of the portfolio is based on an analysis of macroeconomic indicators (growth, inflation levels, central banks, commodity prices, etc.) and then determined the growth and inflation outlook by country, which makes it possible to decide the geographical allocation of the fund. The fund is invested in inflation linked bonds issued by eurozone countries, namely Germany, France, Italy and Spain. It does, however, have the option of diversifying outside the eurozone for up to 20% of the portfolio1, for the UK and the US, which we have already done in the past but which we do not currently consider appropriate due to the already high levels of expected inflation in the United States and particularly in relation to the eurozone.
When constructing the portfolio, we also rely on the analysis of technical elements (flows, carry, etc.) as well as on valuation levels ('price' inflation level for each security).

Written on 04/11/2021

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