Analysis: Trying to call inflation is a fool’s game

FS Rob Gleeson 160 byline

Inflation is the big issue facing fund managers at the moment, with much of the industry either reassured by the lack of it, or worried about its potential. This is a topic that is provoking some pretty extreme views and not just from the usual section of conspiracy theorists.

The debate is polarising the industry, with two broad camps forming which are being dubbed inflation hawks and inflation doves by those with the compulsive need to group and label people. Even within each camp however, there are wildly different estimates of the scale of the problem. Estimates of future inflation vary, from a Japanese style deflationary period, right up to a Zimbabwean collapse in the modern monetary system. While most fund managers can be judged moderates – expecting inflation to be a bit above or below average, the high number that are veering towards the extreme end of the spectrum suggests we truly are facing an extremely uncertain future where inflation could perceivably be in a wide range of values.

The case for high inflation is primarily centred on the effects of the unconventional monetary policies being pursued by the US and UK, with the European Central Bank  slowly getting in on the act as well. By dramatically expending the money supply without any corresponding increase in output there will too much cash chasing too few goods, which ultimately must be inflationary. How pronounced this effect will be is highly contentious, especially since the extra currency gets recycled multiple times through the reserve banking system. Additionally, there is the fear that by becoming the lender of last resort to governments, central banks will be unable to take corrective action without effectively bankrupting their home nations.

Mervyn King, the governor of the Bank of England, has hinted it could be willing to use higher inflation expectations as an part of its policy response to the current economic situation, which makes the above average inflation scenario seem quite likely. Meanwhile the extreme case is that people lose faith in the pieces of paper altogether and no longer regard them having any worth at all, at which point the monetary system breaks down and we return to bartering for everything. This is also being talked about quite excitedly – and by people who would not normally be regarded as excitable.

High inflation erodes the real value of a portfolio, and this needs to be protected against. There are several asset classes that traditionally have offered reasonable inflation protection that are relatively easy to gain access to. Not all have performed as would have been expected however, with many suffering from a number of economic factors that have overshadowed their response to inflation alone.

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One obvious starting point is inflation linked bonds. As the coupon paid by these bonds is indexed to the rate of inflation, and usually reset every six months, they offer protection both to capital values and income. The IMA Index Linked Gilt sector has consistently offered a positive a real return and with this relatively small sector the M&G Index Linked Bond fund stands out. Coming from M&G’s fixed income team it has also outperformed the sector index over the five years to 23 October 2012. Alternatively Newton’s Index Linked Gilt fund, the only one to outperform M&G’s over the period, could also be considered.

A traditional defence against moderately high inflation has been equities. The purchasing power of income is protected as shareholders will always demand a real return on their investments, forcing businesses to pay out higher dividend rates to attract investments. While at the same time, the higher rates will attract investors seeking income protection who would otherwise be in low yield assets such as bonds, thus raising demand and pushing up capital value as well. This might be true when inflation is driven by excess demand in a strong economy, but in the current environment the IMA UK All Companies sector has failed to provide a real return over the past five years, making a nominal 5.23 per cent, but a real loss of 11.67 per cent.

If you are a bit more extreme in outlook, with not an insignificant number of people predicting the end of the fiat money system altogether, then it is best to hold physical assets.

Gold is the obvious choice despite its record price levels. As a homogenous, globally traded commodity, its value tends to increase anytime the threat of inflation rises anywhere in the world. Part of gold’s recent performance is attributed to the rising inflation levels in Iran increasing its demand. The short to medium term outlook for gold prices make this a reasonable choice, although it offers nothing in the way of income it is a good way to protect the real capital value of a portfolio.

The S&P GCSI Gold Total Return Index has gained 177.57 per cent over the last five years while the Retail Price Index has only increased 16.9 per cent. The difficulty with investing in gold is that unless you physically have it in you hand, you are just as exposed to the system of inter connected promissory notes as you are with equities or any other paper asset. An exchange traded fund linked directly to physical gold such as BMG – Gold Bullion could be a good choice. Alternatively the more traditional method of gaining gold exposure through an equity fund focusing on gold mining companies lends itself to funds such as Investec Global Gold or the racier small cap focused MFM Junior Gold could be considered.

Raw materials such as oil, food and other industrial metals and minerals are likewise relatively good bets in a high inflation environment. These physical assets can not be debased by simply conjuring more up, and as they will always be in demand, their value is reasonably assured.

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The economic headwinds facing the global economy have seriously hit demand for commodities, and in the current environment they are not performing particularly well, making a real return of 24.04 percent in the last five years. Longer term they are likely a better bet and again an ETF such as Amundi ETF Commodities S&P GSCI Agriculture or Amundi ETF Commodities S&P GSCI Metals could work well. A commodity focused fund can also be a useful addition to a portfolio such as Barings 5 crown rated Global Agriculture fund or Guinness Asset Management’s Global Energy fund.

Alternatively there are still a significant number of people arguing that deflation is the true threat. The additional increase in the monetary base won’t be inflationary because there is actually a lot of spare capacity in the economy – even more than was previously imagined according to a recent study by Capital Economics. The more extreme interpretation is that this spare capacity is actually at critical levels and that the government austerity program will depress demand even further, causing a spiralling round of price cuts as businesses try to clear their inventories.

As people refuse to spend and lend, cash gets increasingly stockpiled in bank vaults, actually reducing the amount of money in circulation. This was the case with Japan for over a decade following its banking crisis in the 1990’s, and was the biggest fear among central bankers following the credit crunch, which prompted their unconventional responses.

While government bonds are being viewed with increasing suspicion at the moment as markets worry about rising debt levels and, should inflation start rising, there is the possibility of an interest rate hike decimating capital values. If you buy into the idea of a liquidity trap and the possibility of deflation, then the same economic reasoning also suggests interest rates will remain low, and that government debt levels are not a problem. Low government bond yields are a product of excess savings and have nothing to do with “market confidence” in austerity or central bank intervention.

This makes funds such as Swip’s Defensive Gilt a good choice for investors looking to protect their capital. Its focus on short term government bonds makes it extremely low risk, and in a low inflation and interest rate environment a very good way to protect the real value of your investments. It should be noted that fund manager Graeme Caughey actually has a high inflation outlook, making the fund a relatively good choice for investors who want to hedge their bets.

In a full blow deflationary environment gold again is viewed as the ultimate bunker asset, providing a good store value, just like it does in a high inflationary one. However, unlike in a high inflationary environment real assets such as oil or other commodities fall in price as demand continues to shrink. Additionally equities also do very badly in a deflationary environment as was seen in Japan.

While cash and bonds are a good way to maintain purchasing power, ultra-low interest rates will offer virtually no income and investors will have to drawdown their savings. High yield corporate bonds will offer some yield but will suffer from the same difficult corporate climate as equities thus increasing default rates, making government bonds the only real choice. Again this is exactly what happened in Japan, allowing the government to borrow incredible amounts – its deficit is 230 per cent of GDP, far greater than Greece’s – without interest rates increasing.

As a portfolio manager or adviser; it is a fool’s game to try and guess the likely outcome and instead the prudent course of action is to take sensible precautions to protect your investments from either an inflationary or deflationary scenario. In truth there is little that can be done to protect against deflation which explains why central banks are willing to risk overshooting. A well-diversified, defensive portfolio is likely to cover most scenarios; with a stock pile of bottled water and ammunition still the best bet should the monetary system collapse all together.


Rob Gleeson is the head of resaerch at FE