Yesterday’s cooler than expected UK inflation print doesn’t tell the whole story, when it comes to the outlook for bond markets according to AJ Bell. In the following analysis, James Flintoft, head of investment solutions at AJ Bell, shares his thinking on what these latest data mean for gilts and corporate bonds in the weeks and months ahead saying:
“While a softer inflation print gives the market some breathing space, it doesn’t erase the structural inflation story. Inflation is still nearly double the Bank of England’s target of 2% and service sector inflation is sticky. There needs to be big improvements before we can say we’re back on the path to 2% and that long dated gilt pricing is justified. The gilt curve still looks stretched given the broader backdrop.
“As the Bank of England governor stressed in his speech last week at the Group of Thirty 40th International Banking Seminar, supply-side shocks now matter more than demand in shaping growth and inflation. The inflation game has changed. Persistent supply constraints, from energy to trade to demographics, are holding inflation up.
“The UK yield curve looks too flat for this reality. Stubborn inflation, and persistent fiscal meandering, means long-end yields will have to work harder to attract buyers. This isn’t the Quantitative Easing (QE) era – the Bank of England isn’t going to cap the curve because inflation is hot.
“For investors in gilts, the message is simple: yield curve shape matters more than ever. Bailey’s right to highlight supply shocks, the market just hasn’t priced them properly yet, and that could see the UK curve steepen.
“Credit markets have shown quiet resilience through this inflation cycle. Many corporate issuers entered the period with healthy balance sheets, longer-dated funding, and a focus on cash-flow discipline. Inflation has lifted nominal revenues, helping well-managed businesses maintain margins and service debt more comfortably than expected. The result has been credit spreads that have ground lower.
“Some investors will be questioning what role corporate bonds play in their portfolios going forward. While the headline yields are still attractive and an extra buffer against inflation, we are seeing some default headlines that suggest lending standards have been a touch loose. So far, those signs are only emerging within more unusual parts of the credit universe as we have seen with the First Brands and Tricolor sagas.
“From an AJ Bell Investments perspective, we believe diversification is key in bond markets and it is often overlooked. Holding some higher risk credit, but not too esoteric, such as high yield bonds and emerging market debt where you can still get a yield of over 6%, has been a good place to benefit from the wider risk-on sentiment in markets and avoid the volatility in the gilt market. Lower risk allocations to bonds are still possible by limiting duration in government bonds, and protection from inflation can be sought in real bonds such as US TIPS (inflation-linked US Treasuries).”