At Aitken Investment Management (AIM) we strongly believe 2017 will be the year when inflation surprises on the upside. We have our fund positioned short bonds and certain “bond quasi” defensive equities around the world, vs. longs in companies we believe possess genuine pricing power such as Treasury Wine Estates (TWE) and Aristocrat (ALL) in Australia for example. We are also long cyclical companies all around the world.

We also believe central banks will be forced to abandon zero interest-rate interest rate policies (ZIRP) and wind back QE. We simultaneously expect governments to take over the heavy lifting via expansionary fiscal policy, led by the USA with its “America First” strategy. Populist politics equals fiscal spending and protectionism. Austerity is so dead, ZIRP is dying and QE was just a waste of money.

The combination of higher than expected inflation, central banks shrinking their QE policies/abandoning ZIRP, and fiscal stimulus is a genuine triple threat to the bond market bubble. And make no mistake, bonds are a tremendous bubble which as we have said before are “real return free capital risk”.

The other angle to consider is: who is going to be the marginal buyer of long bonds as all this unfolds? It won’t be China. They’ve been selling US Treasuries for six straight months now. It won’t be the Federal Reserve. They have started flying the flag about NOT reinvesting the proceeds of maturing bonds in their portfolios. These are two MAJOR developments in terms of multi-year buyers effectively becoming sellers.

Obviously, a disorderly bond market rout wouldn’t be good for equity markets in the shorter-term, particularly considering that 75% of all gains in US equities over the last five years have been driven by P/E expansion, not earnings or dividend growth. Similarly, debt funded buybacks have also played a major role in US equity gains, while the “yield trade” drove capital gains in anything that resembled a bond globally.

However, we feel the greater capital loss risks lie in long bonds themselves and in equities there will be selected beneficiaries of rising long bond yields driven by inflation. The great rotation from bonds to cyclical equities has clearly started. Either way, if we are right about our inflation and bond view in 2017, then there will be major cross asset class volatility.

In volatility there is genuine investment opportunity and you can understand why we are so excited about what lies ahead. It’s going to be a great period to be a nimble global hedge fund with a broad mandate. 

Last week we saw clear evidence that full employment in the USA is driving inflationary pressure. The Fed’s preferred measure of inflation, excluding food & energy, reached +1.6% in the 12 months through November.

More importantly, average hourly earnings rose +2.9% in December from a year earlier, the biggest jump since 2009.

This gives us even greater confidence the Fed’s 2% inflation target will be exceeded this year and you can understand Mrs Yellen is now jawboning to a “few” rate hikes this year.

Similarly, The Federal Reserve Bank of Atlanta’s wage growth tracker is now +4.4% year over year. Oil prices have doubled since last January, which likely means headline US CPI will be printing north of +3% in April.

It’s also worth remembering we haven’t yet seen the effects of “Trumpflation” which will be large in terms of wage pressure and product pricing to consumers (tariffs etc.).

Amazingly, with US inflation clearly tracking higher, a US 30-year bond still yields around 3.00%. In effect, 0% real, if we are right in our inflation view. You can understand why we are short US 30-year bonds at what could be 0% real.

But rising inflation isn’t a US centric story. Inflationary pressures are rising in the Eurozone too.

Inflation in Germany is +1.7% and will probably rise above 2% in 2017. Yet, we sit here and a German 10-year bund yields 0.37% due to the continuous QE buying of the ECB.

You can understand why we are also short German 10-year bunds at what is effectively a -1.50% real yield. I actually think shorting German bunds is one of the great risk/return trades on the planet. Time will tell if that’s correct.

Just to remind you how badly mispriced a US 10-year bond currently is, we’ve looked back at the relationship between 10-year bond pricing and the inflation rate.

Since 1960, the US 10-year bond yield has averaged a 2.50% premium to the core inflation rate. Right now that premium is 0.4% and core inflation is rising fast.

If US bond yields were to revert to the historic average premium to core inflation, a US 10-year bond would be 4.60% versus 2.50% currently.

That simply reminds you of the magnitude of this mispricing and what terrible, terrible value long bonds are.

If our inflation view proves correct, you would expect core US inflation to rise to 3% to 4%. That’s what full employment, consumer confidence and a pro-business government can achieve. But for long bonds, that’s a disaster and there is clearly a scenario where the US 10-year bond yield doubles before the next US recession.

The so-called “risk free rate” has never been riskier…..

Let’s look at a series of charts that underlie our views on inflationary pressures surprising on the upside.

US wage inflation

China PPI YoY change (%)

Citigroup Inflation Surprise Index – Global

Citigroup Inflation Surprise Index – Eurozone

JOC – ECRI Industrial Commodity Price Index

Bubbles very rarely burst in an orderly fashion. Remember oil? This bond bubble deflating will be quicker than most expect due mainly to the fact we have seen 35 years of gains and excess built up. And simultaneously it is hard to identify who the marginal buyer will be, as capital losses stack up. In fact, it’s far easier to identify marginal sellers as capital losses stack up.

The AIM Global High Conviction Fund is “high conviction” on our view of inflation and we have great conviction in our short positions in bonds.

This again reinforces why we are different to other Australian based global funds. We are short bonds.

Below is a very long-term US 30-year bond chart, which reminds you where we are in yields versus history.

It’s going to be a year of volatility and opportunity. I look forward to commentating on it for you over the weeks and months ahead.

However, I want to start the year by strongly warning you that bonds will most likely see capital losses this year, as yields rise to reflect rising inflationary pressure. It is time to protect your portfolio from inflation via owning equities with pricing power and dividend growth.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.