After a sustained period of steady – albeit historically-low – growth, the global economy is warming up and the calm in financial markets is beginning to break. 
We believe the shift to higher volatility – evidenced in the first half of February – is structural, not temporary, and directly related to expectations for elevated inflation and higher interest rates.
Wage pressure is continuing to intensify in the US, largely due to capacity constraints and low levels of unemployment. In fact, the publishing of the wage inflation figure was the major factor behind the equity market wobble last month.
In addition to wage inflation, we are also witnessing changes in the balance of commodity markets and the US dollar. Commodities sold off aggressively in the years following the financial crisis, which has a major impact on inflationary pressures. At the same time, the US dollar rallied more than 35 per cent against world currencies, another deflationary force. If you believe commodity markets bottomed in 2016 and the US dollar peaked last year, you should expect very different inflationary dynamics in the coming months and years.
As such, we expect headline CPI in the US to move towards 2.5 per cent by the end of 2018, up from the current level of 2 per cent. This will put steepening pressure on the US curve, given the low inflation expectations priced in the market.
Short duration and inflation protection
What are fixed income investors to do to combat the threat of rising inflation? The most obvious method is to buy securities offering built-in inflation protection. We currently have 16 per cent of our Global Bond Absolute Return portfolio and 13 per cent of our Global Opportunistic Bond strategy allocated to inflation-protected securities, primarily through US TIPS. We believe the US economy will reflate beyond recent trend growth, despite falling short of pre-crisis levels.
In addition, we are also implementing negative headline duration in our portfolios. We do not believe the currently low sovereign bond yields faced by investors today can be sustained indefinitely – particularly considering the rise of inflation, the improved economic outlook and the continuously improving labour market situation.
As mentioned, we believe the extremely gradual pace for hikes priced by markets is a low bar to exceed, even if the path of hikes is likely to be slow. Our short duration position is expressed through both US and German government debt.
Where are the credit opportunities?
Elsewhere, we continue to have exposure to European high yield credit, but this position is partially hedged using CDX. The European high yield sector continues to benefit from limited commodity exposure and lesser sensitivity to changes in US monetary policy.
At the same time, the market is still well supported technically by the European Central Bank’s investment grade corporate bond purchases – which is depressing yields and spreads beyond the target universe. Projected default rates remain subdued, which in relation to improving fundamentals, maintains the attractiveness of the risk premium offered by European high yield credit spreads.
Despite this, we currently partially hedge our European high yield bonds through credit default swaps, reducing the effective credit sector exposure as valuations are at recent tights. We believe volatility may emerge from potential monetary policy surprises and political risk on the horizon.
Jon Jonsson is portfolio manager of Neuberger Berman’s Global Bond Absolute Return and Global Opportunistic Bond funds. The views expressed above are his own and should not be taken as investment advice.