As Covid optimism grows, investors seek to hedge against inflation risk

The global reflation trade means a change of strategy on portfolio protection

Gavyn Davies 

Economic forecasters have been scrambling since mid-year to upgrade their real GDP growth projections © Angela Weiss/AFP/Getty


With optimism rising about the roll out of Covid-19 vaccines, financial markets have been gripped by a global “reflation” trade, implying faster growth in nominal gross domestic product and company profits.

Economic forecasters have been scrambling since mid-year to upgrade their real GDP growth projections once the current waves of the virus are controlled.

Inflation is anticipated to remain well below central bank targets for the next two years. 

However, US inflation expectations are rising and huge increases in public debt and central bank balance sheets are causing many investors to think seriously about how to protect their portfolios from inflationary risks.

A recent note by Fulcrum economists argues that this is no easy task — so how can it be done?

A portfolio shift away from conventional bonds into equities might seem appropriate, because equities might benefit from an increase in the inflationary element of corporate earnings.

In the very long term that should work, but the time span needs to be measured in many years. Over shorter periods — which matter greatly to many investors — unexpected inflation is often bad for equities because it leads to tighter monetary policy, rising real interest rates and future recessions.

Peter Oppenheimer of Goldman Sachs has shown that an unexpected rise in US inflation above 2-3 per cent usually harms equities, eliminating their value as an inflation hedge just when it is most needed. The same can be true of some other assets, such as real estate.

During the great inflation shock of the 1970s, global equities and bonds suffered in tandem. 

Standard US portfolios, holding 60 per cent equities and 40 per cent conventional bonds, produced real returns of minus 1.5 per cent a year during the entire decade. In the first three years of the inflation shock from 1971-74, investors lost 10.5 per cent a year in real terms in these portfolios.

A repeat of such disastrous events seems improbable, but that unlikely risk is what tail protection for portfolios needs to address.

Inflation-protected government bonds (Tips) were introduced in 1981 in the UK, and 1997 in the US, for precisely this purpose. If held to maturity, these provide a return equal to the current real bond yield plus the actual rate of inflation. 

They are free of default risk, even in the case of hyper inflation, so are good long-term hedges against inflationary Armageddon.

However, investors have already taken note of these advantages, so real yields on these bonds have been driven heavily negative. 

Ten-year index-linked bonds now offer real yields of minus 0.9 per cent in the US, and minus 2.9 per cent in the UK — that is a hefty insurance premium to pay.

Furthermore, while Tips offer excellent protection against very high inflation in the long term, over periods shorter than the time to maturity, they can be extremely volatile because real yields can change sharply. 

A rise of 1 percentage point in the real yield on 10-year Tips from today’s extremely low levels would reduce the market value by about 10 per cent, imposing a mark-to-market loss on existing holders.

Investors should therefore consider other hedges. Sudden periods of rising inflation, even outside the 1970s, have frequently coincided with oil price surges.

Direct exposure to the energy complex, for example through oil futures or exchange traded funds, is therefore likely to bring high returns at such times. 

Gold may have similar advantages, though quarterly correlations with inflation have faded since the 1970s.

Another option would be short-dated Treasury bills, or floating-rate debt. This may seem counter-intuitive, since the value of near-cash assets would be rapidly eroded by inflation if short-term interest rates remain fixed. 

However, short term rates are in fact likely to rise sharply under conditions of a severe inflation shock, because central banks are bound by their inflation targets to tighten monetary policy.

Traditional monetary policy rules, such as the Taylor Rule, often indicate that nominal interest rates should be increased by about 50 per cent more than the rise in inflation, so the real return on interest-bearing liquid instruments should rise fairly swiftly if inflation exceeds 3 per cent.

In summary, a combination of Tips held to maturity, commodity-related assets and short-term Treasury bills is likely to offer reasonable protection against inflation shocks.

But these hedges need to be actively managed, since their performance would be affected by the specific characteristics of any inflation shock. 

Furthermore, inflation hedges — like any other form of insurance premium — are costly, reducing asset returns when inflation remains under control.

Reducing inflationary tail risk is certainly not a free lunch.

The Debt Dogs that Didn’t Bark

If global growth resumes in 2021, aided by the rollout of vaccines and the Fed’s continued commitment to ultra-low interest rates, some developing countries may be able to avoid default, because yield-hungry investors will continue to buy their bonds. But other countries will not be so lucky.

Barry Eichengreen


BERKELEY– Last March, when COVID-19 infected the world economy, many observers feared that emerging markets and developing countries would suffer the most, financially and otherwise. 

Economically, they relied on commodity exports, remittances, and tourism, all of which fell through the floor with the pandemic. There was every reason to expect a tsunami of financial crises and debt defaults.

The tsunami never arrived. Just six countries – Argentina, Ecuador, Belize, Lebanon, Suriname, and Zambia – have defaulted on their sovereign debt, and only the first two have restructured their debts.

But much like Sherlock Holmes’s dog that didn’t bark, it’s hard to know whether to be reassured or alarmed by the silence. Reassuringly, the impact of COVID-19 on developing countries, in Africa specifically, has been less than feared. Their young populations are relatively resistant to the coronavirus. 

Their health systems, in responding to past epidemics, have gained the public’s trust. 

And China’s quick recovery boosted demand for their commodity exports.

Financially as well, current conditions are surprisingly stable. 

In March, when the crisis erupted, emerging markets hemorrhaged capital. In April, however, the outflows tailed off, and net flows to emerging economies have been positive and growing since.

It is not hard to see why. 

Yields on US ten-year Treasury bonds are below 1%, and the dollar is widely expected to depreciate. European government bond yields are negative. 

In this environment, a Thai government bond yielding 1.35% is irresistible, even though Thailand displays classic signs of financial trouble ahead: a tourism-dependent economy expected to contract by 7% this year and a government that lacks popular support.

If global growth resumes in 2021, aided by the rollout of vaccines and the Fed’s continued commitment to ultra-low interest rates, some developing countries may skate through. Yield-hungry investors will continue to display an appetite for their bonds.

But other countries, having been hit harder by declining export earnings and collapsing remittances, will have obligations to meet. The Institute of International Finance estimates that nearly $7 trillion of emerging-market debt will fall due in 2021, triple this year’s level. 

This is not a crisis that will materialize at some indeterminate future date. The dog will start yowling next year.

Where governments have issued debt domestically, their central banks can buy it up, but only at the cost of crashing the currency and scaring off private investors. In addition, twice as much foreign debt is coming due in 2021 compared to this year. 

Much of this has been rendered effectively unpayable by the economic shock of the pandemic.

The G20 has responded with a Debt Service Suspension Initiative (DSSI) that allows 73 low-income countries to defer payments on their government-to-government debts for a year and a half. The single largest bilateral creditor, China, is now on board, after some initial hesitation.

The DSSI is imperfect. Limiting the duration of the suspension and deferring rather than forgiving the interest is a bit miserly. Countries are reluctant to apply for fear of rating-agency downgrades, as happened to Cameroon. Distressed middle-income countries are excluded. Still, something is better than nothing.

The problem is getting private creditors to scale back their claims. Last April, the G20 “called on” private creditors to agree to comparable concessions. Unsurprisingly, their calls went unheeded. Investors were more concerned, predictably, with their own portfolios than the plight of low-income countries.

Subsequently, G20 governments made clear that they had no intention of deferring their claims if the money this freed up simply went to pay off private creditors. But the private sector has made equally clear that it has little interest in concessions. 

History tells us that private debts are restructured only when creditors become convinced that half a loaf is better than none. And investors are still hoping for the full loaf, with the official sector helping to feed it to them.

What more can be done? The United Nations Security Council could pass a resolution instructing its members to shield the assets of low-income countries from litigious creditors, much as it shielded Iraqi assets following the removal of Saddam Hussein. 

The US Congress could give this measure force of law. Or, after January 20, 2021, President Joe Biden could issue an executive order instructing the courts to proceed accordingly, as President George W. Bush did in the case of Iraq in 2003.

Is there a chance of this happening? 

Consensus within the UN Security Council is hard to achieve and even harder to maintain. The incoming Biden administration will have limited political capital, limited bandwidth, and an abundance of other problems. 

Whether it will be prepared to confront the big institutional investors – can you say BlackRock? – remains to be seen.

I am optimistic about economic recovery in 2021, but I am less optimistic about the political wherewithal to muzzle the debt dogs. 

It would please me greatly to be proved wrong.


Barry Eichengreen is Professor of Economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His latest book is The Populist Temptation: Economic Grievance and Political Reaction in the Modern Era. 

The valuation warning signs for stock markets

Current investor complacency about global equities might soon be tested

Ian Harnett 

Investors remain overweight equities even though US valuations have returned to levels last seen in the January 2000 dotcom boom © Financial Times


The rationale behind the current optimism among many equity investors is shifting as markets emerge from the pandemic shock. 

In the yield-starved pre-Covid-19 world, a common mantra of the bulls was the acronym TINA — there is no alternative. Now that has mutated to TRINA — there really is no alternative.

Investors remain overweight equities even though US valuations have returned to levels last seen in the January 2000 dotcom boom. Are investors right to be so bullish when share prices are so high relative to earnings and cash flow?

Although every market rally derailment is different, there are common themes that occur on most occasions. The first is the role of implicit assumptions that may appear bullish but can also be seen as an important risk factor. 

Second, there is never a single cause: it is always the layering of risks and assumptions that leads to the ultimate crisis. The current complacency about global equities has many of these characteristics.

Inherent in the current market optimism are three crucial assumptions. First, valuations do not matter any more. Second, interest rates will stay low for an extended period. And third, loose monetary and fiscal policy combined with the Covid vaccine will return us to the “status quo ante” and the investment regime of the past five years.


The reality is that equity valuations always matter. Less so in the short run, but more so in the long run. One benchmark is when the ratio of US share prices to earnings over the previous 12 months rises above 30. Since 1950, whenever that threshold has been brea

ched, the subsequent 10-year annualised returns for US equities have rarely been above 5 per cent and often below minus 5 per cent.

Our own valuation composite, which combines six common valuation metrics such as prices relative to earnings and cash flow, shows valuations more extended than at any time since January 2000. 

A similar story is shown by the “Tobin’s Q” ratio popularised by American economist James Tobin, which measures the market value of a company relative to the replacement cost of its assets. That ratio is back to levels seen only once since 1950 — in January 2000.

The pushback to concerns raised about such levels is that traditional valuation metrics are less meaningful given that future earnings are discounted by rates now close to zero.

I worry, however, that these bullish investors are looking to “have their cake and eat it”. They expect unemployment to fall and earnings to post a healthy recovery yet expect policymakers to keep interest rates on hold and bond yields to remain low and stable. But at what point will policymakers decide that they have done enough? 

They will be keen to avoid a repeat of the ‘taper tantrum’ in markets in 2013 when the US Federal Reserve signalled a tightening in policy. However, policymakers may find it hard to control longer-term bond yields if current expectations of the economic and earnings recovery play out.

The danger in relying on overvalued bonds to justify overvalued equity valuations is that any volatility in rates, driven by activity or inflation, could destabilise the equity market complacency. 

The combination of both bond and equity valuations being this stretched has only been seen twice since 1950 — in 1998-99 and 1986-87. Neither of those periods ended well.

Implicit in the relaxed consensus about equities also appears to be a view that the vaccine will deliver an extension of the previous cycle and a return to the status quo ante. 

We suspect that a sell-off in early November of some of the more faster rising stocks provided a warning shot that the world has changed.

Investors are now focusing on the scope for cheaper stocks to outperform as earnings become more plentiful and margins recover toward their 2018 peaks. However, a greater focus on value means a greater focus on valuations. 

Investors looking to buy cheaper ‘value’ stocks will become more wary of buying growth stocks which command a premium because they have higher potential earnings.

The good news in 2021 is the likelihood of a meaningful economic recovery. 

The bad news, however, is that this very success could usher in a new investment regime that will probably challenge many of the assumptions on which current valuation optimism is based. 

Sometimes it isn’t what you know is risky that is dangerous, it’s the things that you think are safe but aren’t that are the problem.


The writer is co-founder and chief investment strategist at Absolute Strategy Research

Absolute Strategy Research co-founder David Bowers contributed to this article

Russia Plays Both Sides in Germany

Moscow knows it doesn’t have much economic leverage right now.

By: Ekaterina Zolotova


On Dec. 8, a delegation from the AfD, a far-right German opposition party whose interests in the country tend to align with Russia’s, arrived for talks in Moscow. 

Russian Foreign Minister Sergei Lavrov made a rare appearance at the meeting. 

Also early last week, Russian President Vladimir Putin held a phone call with German Chancellor Angela Merkel after a considerable period of abstention. 

The reason for the uptick in attention Russia is paying to Germany is simple: Berlin hopes to restore ties under the Biden administration, and Russia doesn’t like that. 

So Moscow is trying to make inroads with Germany while it can, influencing domestic politics and ensuring that bilateral trade and economic relations will grow despite Germany’s turn to the United States.

Russian-German relations have always been one of the issues around which European politics revolves. Historically, Russia has been uniquely vulnerable to invasion from the west, and that westerly threat is never so potent as when it includes Germany. 

Maintaining friendly relations with Berlin through trade and commerce is therefore a matter of national security for Moscow. 

They disagree on any number of issues, but both recognize the complementarity of their relationship: Both of their economies depend on exports, and each has stuff the other needs.



But for obvious reasons, Germany prefers to have excellent trade relations with anyone who wants German goods. Largely this is because the German economy is the foundation on which the European Union is built. 

But since almost 40 percent of its gross domestic product is generated by exports, churning out goods for outside consumption is tantamount to German geopolitical power more broadly. (This is all the more important as its economy recovers from the COVID-19 pandemic.) 

Germany has therefore indicated clearly that it is ready and able to integrate with the U.S. further and hopes that the election of Joe Biden means the U.S. will reciprocate in kind.

The U.S. is Germany’s top export destination, so it doesn’t make much sense for Berlin to forego U.S. markets simply because it also has strong ties to Russia. And in fairness, Moscow never really expected it to, even when U.S.-German ties soured somewhat during the Trump administration. 

However, it hoped to capitalize on some of the bad blood – caused partly by protectionist trade policies, Washington’s attempt to sell liquefied natural gas in Europe, and the sanctions levied over the controversial Nord Stream 2 gas pipeline – by emphasizing the practicality of Russo-German commercial interests.

Despite these hiccups, the U.S. and Germany are still close partners, and Berlin’s recent overtures are creating more tensions between Russia and Germany. (“More” in that tensions were already present thanks to the events surrounding Nord Stream 2 and the poisoning of Russian opposition leader Alexei Navalny.) 

Moscow understands that the German economy is looking for bigger, more solvent markets, and that it doesn’t have a ton to offer more than what it already does. 

It needs a fresh start, but for that to happen, Germany must first lift sanctions – something that is unlikely to happen so long as Berlin refuses to recognize Crimea as Russian territory.

Sanctions, however, cut both ways. Experts from Germany’s Ifo Institute for Economic Research estimate that the sanctions imposed on Russia in response to Crimea (and to Russian activity in Donbass) have cost the German economy 5.45 billion euros ($6.61 billion) annually. Processing and chemical industries, as well as the automotive and mechanical engineering industries, were hit particularly hard. 

The head of the Center for the Promotion of Economic Cooperation between Germany and Russia has noted that if the sanctions were lifted, Germany would be able to increase its exports to Russia by more than 15 percent. 

Russia meanwhile remains a reliable source of cheap gas for Germany, which relies heavily on foreign gas supplies, despite a drop in supplies due to COVID-19.

Without traditional tools to put pressure on Berlin, Russia sees one point of leverage: trying to curry favor with certain legislators ahead of legislative elections in nine months. The German economy was slowing even before COVID-19. Different German constituencies have questioned the direction the government should take after the pandemic, specifically challenging the status-quo Merkel established. 

By reaching out to parties like the AfD, Russia is getting a feel for how the political winds are blowing and how it can best position itself for any outcome. Russia has chosen a low-cost strategy toward Germany by simultaneously strengthening ties with opposition parties and the ruling coalition alike. 

AfD has lost some of its numbers, but it is still a viable alternative to the status quo, and since most of its support is found in east Germany, it’s the preferred party of Russia.


Russia does not have many economic tools to improve relations with Germany, but it’s trying to acquire whatever leverage it can by playing internal political parties against each other. 

For now, it can sit back and observe how the parties evolve so that it can step in if and when the system starts to change.