The liquidity created by the resumption of quantitative easing in America will ultimately have to find a home.
Economists are speculating where that home might be – gold, emerging markets, government bonds? – but investors are increasingly worried that it will manifest itself in inflation. This view seemed to be supported by the recent British inflation, which surprised economists. The Consumer Prices Index rose 3.2% in the 12 months to October, up from 3.1% in September, propelled by higher petrol prices.
The fund management industry has hit on several solutions. Aegon has just launched a retail share class for its institutional inflation-linked product, which invests in a blend of index-linked bonds and other inflation-protected assets such as commodities, equities and high- yield bonds. In September M&G launched an inflation-linked corporate bond fund focusing on investment grade debt, floating-rate notes and inflation-linked bonds.
Although the funds take a slightly different approach, both are substantially invested in index-linked bonds. Stephen Jones, the manager of the Aegon fund, says that at its launch the portfolio will have about 70% in the asset class. However, over the long term it will have few constraints. “Index-linked bonds are quite expensive at the moment and only capture the end point of price rises, through RPI [Retail Prices Index],” he says. “We also wanted to capture the remainder of the price pipeline, through investments such as commodities, to preserve real value.”
The fund is compared with an investment-linked bond index rather than RPI for that reason. Jones says this type of fund lends itself to longer-term liabilities and it has found resonance with pension investors. But is inflation a big enough risk to merit an investment in specifically inflation-targeting funds? (article continues below)
Experts are divided. On the one hand, inflation has proved stubbornly high and VAT rises in January will not help. On the other, public sector cuts are likely to be deflationary.
Mervyn King, the governor of the Bank of England, in his comments accompanying the Inflation Report, said there was only about a 25% chance that inflation would be within 0.5% of the Bank’s target. In other words, the forecasts may be wrong. The Bank is itself divided, with Andrew Sentance still voting for a rise in rates to curb further inflation.
A similar schism is seen among economists and bond fund managers. Keith Wade, the chief economist at Schroders, says: “Inflation will continue to surprise on the upside and could be as high as 4% early next year. There is uncertainty about whether retailers will pass on the VAT rise, but food inflation is likely to continue to rise.”
On the other hand, Stewart Cowley, the manager of the Old Mutual Global Strategic bond fund, says if inflation is a risk, it is a longer-term risk. In the short term government bond yields are likely to head towards Japanese levels. However, he concedes that plenty of people are worried about inflation. “Real yields on some inflation-linked bonds are currently negative – investors effectively pay the government in order to own them,” he says. “Clearly some people are extremely worried about the creation of inflation via quantitative easing and willing to pay almost anything to get protection.”
This is the biggest problem for these new inflation-linked products. M&G and Aegon admit that the inflation-linked bond market is already expensive. Patrick Connolly, the head of communications at Chase de Vere, says that this is part of the reason that, while the group supports Aegon’s and M&G’s fixed interest teams, it is not recommending their inflation-linked products, though he can see their attractions.
“This type of fund is likely to prove popular as many investors remain nervous about the effects of inflation,” he says. “The recent withdrawal of National Savings & Investments Index-Linked Savings Certificates has given investors little scope to invest in products or funds that are aimed at giving inflation-proof returns.” These funds can be expected to perform well when inflation is rising, but what happens if inflation is more subdued, as the Bank says it will be?
Jim Leaviss at M&G says a protracted disinflationary period is likely but its fund has been launched because some investors are worried about inflation.
Investors are nervous about how inflation will erode the long-term purchasing power of their income. In this case, these funds make perfect sense. However, they are buying into assets that already look quite expensive.