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Economic and Market Commentary

European Inflation Update: Higher for Longer but Hedging Remains Well Priced

Despite soaring inflation in Europe, hedges appear cheap

As European inflation hits levels not seen since the 1980s, investors are asking if it’s too late to hedge. Consumer prices in the Euro Area continue to climb, rising 8.1% from a year-ago in May, posing fierce challenges for policy makers trying to contain it without throwing the economy into recession.

European Inflation Dynamics

The dynamics of higher inflation are mostly global in nature. Russia's invasion of Ukraine has upset global supply chains that are still recovering from the COVID pandemic, and cut the supply of many vital commodities, driving prices sharply higher. These pressures – particularly acute in Europe -- are broadening out across countries and products. Production of steel, fertilizer, and paper has shrunk. China’s zero-COVID policy lockdowns are compounding the supply shortages in areas such as the auto sector, which has slowed production, with more delays expected.

Near term uncertainty is very high, but in our base case view, we expect inflation in Europe to peak this year – later than in U.S. – as supply chains recover and monetary and financial conditions tighten.

Still, we believe it will be a slow and sticky process, and remain elevated well into 2023, before gradually moving back toward the ECB’s target -- and the upside risks to our outlook are significant.

Near-term inflation risks appear skewed to the upside

The current environment is uncertain and the range of outcomes for European inflation remains wide. We think the balance of risk is skewed to the upside:

  • Dependence on Russia: The EU’s heavy dependence on Russia for gas and vital agricultural commodities suggests inflation may be more intractable there until it pivots to other sources.
  • Inflation-growth spiral: The longer realized inflation remains high, the greater the risk that behaviors change, leading workers to demand higher wages and consumers to pull forward purchasing.
  • Growth versus inflation trade off: Europe faces a difficult balancing act. Amid weak economic growth, policy makers are boxed in with little room to maneuver relative to their U.S. counterparts, and may need to tolerate higher inflation if the alternative is a policy-induced recession.
  • Fiscal policy: Europe’s move to diversify away from Russian energy imports and to increase defense spending point toward higher government spending over the coming years.

Investment implications

Is it too late to hedge inflation risks? We don’t think so. In our view, inflation hedges remain cheap relative to history and are not appropriately reflecting the upside risks to the inflation outlook, meaning that inflation hedges in Europe may still be attractively priced.

To illustrate this, we look at the 5y5y forward breakeven rate. This rate shows the 5-year expected rate of inflation 5 years from today, giving us a full 10-year period for expectations without the near term noise in the standard 10-year breakeven rate. European 5yr5yr inflation swaps indicate that investors expect a rate of 2.2% medium term, only slightly above the ECB’s medium-term target of 2.0%. Market-based inflation expectations in Europe remain below the post GFC peak reached in 2012 and broadly in line with the ECB target.

Market prices for inflation hedge cheap relative to actual consumer inflation

This chart shows the European 5-year, 5-year inflation swaps, which indicates that investors expect inflation will be just 2.2% over the 5-year period from 31 May 2027 to 31 May 2032. It also shows European inflation, as measured by the European Consumer Price Index, currently at 8.1%.

Source: PIMCO, Bloomberg as of 31 May 2022
FWISEU55 = a market measure of average expected inflation over the five-year period that begins in five years. ECCPEMUY = European Union Consumer Price Index

We believe real and inflation–linked assets can provide investors with a powerful hedge against further upside shocks and improve portfolio level diversification and return potential. Even as the pandemic and war related price pressures dissipate, we think it is unlikely that we return to the pre-pandemic paradigm of low but stable growth and inflation. Rather, we believe over the next five years the global economy will likely experience more volatile, and divergent inflation paths. Against this backdrop, investors should consider the full range of potential outcomes and position portfolios to be robust across a range of macroeconomic environments.

Read more insights on our inflation views.

Lorenzo Pagani is a portfolio manager focused on European government bonds. Peder Beck-Friis is a portfolio manager focused on global macroeconomic trends. John Mullins is product strategist, responsible for global asset allocation and real return strategies. All are contributors to the PIMCO blog.

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The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.

All investments contain risk and may lose value. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world. ©2023, PIMCO.

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