Peripheral European sovereign securities are not the only potential cloud on the investment horizon. Besides the bonds of certain US municipalities, there is a risk that US Treasury securities themselves may come under more intense scrutiny by investors given the large US budget deficit and growing national debt. Figure 8 shows the exponential change in US government debt since the 1950s as well as the relatively moderate increase in GDP. The result is that the marginal increase in GDP per new dollar of US government debt is now only 17 cents in contrast to 70 cents in the early 1950s, begging the question: Is this risk-free return or return-free risk?
Since the US Federal Reserve undertook its most recent round of quantitative easing in the autumn of 2010, the US Treasury yield curve has shifted outward (Figure 9) implying investors are beginning to demand higher (although still historically low) returns even from the almighty greenback.
The conclusion to draw both from the shift in the US Treasury yield curve and from the escalating levels of US debt is that even though investment yields are hovering
at multi-decade lows, there is still almost certainly risk that is not reflected in those low yields.
Another contributor to the valuation trap is the creeping effect “cheap money” may have in heightening forward rates of inflation in certain key economies. Although Japan and most of the major Western economies have been in a disinflationary environment at least since the onset of the financial crisis, certain regions, such as the UK, India and China, have experienced or begun to experience above-trend rates of inflation. Figure 10 attempts to project rates of inflation for the UK, France, the US and other major Western economies using bond market pricing data. Here, nominal to inflation-linked break-even rates are used as the basis for deriving the forward rate of inflation. This analysis can only be undertaken for countries that offer multiple, liquid, short and medium-term inflation-linked sovereign securities. For China, India and Japan, where the range of available securities is less, Figure 11 shows the respective backward-looking consumer price indices.
The takeaway is that buyers of sovereign inflation-linked securities expect the UK to experience higher rates of inflation than the other major Western economies.
Furthermore, rates of inflation, as measured by national consumer price indices, are significantly elevated in places like India and China. Japan remains decidedly disinflationary. This is significant for carriers based in relatively disinflationary regions such as the US or Japan writing medium or long-tail business in relatively inflationary regions such as the UK, China or India. Premiums written today on longer tail lines must not only reflect future claims expectations, but must also allow for a range of inflation expectations depending on the region and line of business.