Following a prolonged period of stagnation, the outlook for inflation is once again looking brighter and as such investors may want to adjust their asset allocation accordingly.

Despite positive economic growth, for a number of years – and especially between 2012 and 2015 – inflation kept disappointing, especially in the Eurozone.

But it wasn’t just the euro area missing expectations as this was also the case in the US and in the UK. In fact the rate of inflation across these three economic regions all collapsed to 0% in late 2015, as oil prices crashed. However there was more to this than just falling oil prices as between 2012 and 2015, underlying or “core” rates of inflation, which exclude food and energy costs, all decreased across the US, the UK and in Europe .

Today the backdrop is much improved. In March, US CPI core inflation gained 2.1% year-on-year, the highest level since early 2017. Inflation in the Eurozone remained stable where in March – and in line with expectations – core CPI came in at 1% on an annualised basis for the third consecutive month. In the UK, the cost of living has eased slightly but is still well ahead of its former lows, with 12-month CPI for March at 2.5%, down from 2.7% in February.

Inflation risks tilted to the upside

Oil prices, due to their volatility, are naturally a strong contributor to inflation and when the cost per barrel bottomed out in mid-2016, inflation finally started to pick up across the globe. But as oil prices are now comfortably above $70 a barrel, we expect inflation to continue to be well supported – and we believe that core prices will also rise in 2018 as the environment of robust economic expansion should lead to increasing services prices. In our view, the link – or inverse relationship – between unemployment and inflation, known as the “Phillips Curve” is alive and well, leading us to believe that it is reasonable to expect that a strong economy, will drive prices higher again.

Rising oil prices and core inflation

Core inflation numbers are particularly important to economists as they are supposed to be shielded from energy prices. But we found that rising oil prices in 2016 led to higher producer prices in 2017 – and we expect that consumer prices will move higher in 2018, as companies pass on rising production costs. Fundamentally, we believe that this is the main upside risk to our higher inflation scenario. In our experience, the inflation-linked bond market has a relatively limited ability to “predict” future inflation. Instead, market-based inflation expectations – or inflation break-evens – tend to move higher when inflation itself moves higher. This is the reason why we currently see value in inflation breakevens.

A simple analysis would show that the International Monetary Fund’s inflation forecasts for 2018, are now higher than most inflation linked bonds’ inflation breakevens  i.e. the embedded future rate of inflation. This suggests to us that market participants are either very skeptical of, or unprepared, for higher inflation. This in itself can create opportunities for others.

During the deflationary years, central banks used all the tools at their disposal to tackle the situation. Balance sheets were expanded and in some countries interest rates were even dragged into negative territory. But as inflation normalises, it is reasonable to expect that monetary policy will follow suit. While this process should push market rates higher, we believe the process will be gradual as the Bank of Japan and the European Central Bank are still accumulating bonds in their respective balance sheets.

As inflation-linked bonds, unlike floating rate notes, do not have a variable coupon and are therefore sensitive to interest rates swings, investors should seek professional advice in order to identify the inflation linked bond strategy, which would best suit their needs and risk tolerance.