Smith & Williamson’s Wells: The inflation conundrum

Investment

For much of the last decade, it seemed that central bankers had won the inflation ‘war’ and that inflation was dead. Indeed, inflation was so dead that if you were Japanese or European, you were probably more worried about deflation.

As is often said, central banks don’t really do deflation, so they were quick to loosen policy and use unconventional policy tools (most notably quantitative easing) to avoid a deflationary bust. Some observers have suggested that QE has to be inflationary in the long-term, perhaps significantly so, but what we have actually ended up with today is an environment of modest inflation.

The question now is: what could happen from here? In the US, we would expect inflation to remain reasonably well behaved and indeed it is has been trending down further from target for the last four months. Doubts remain as to whether Trump really can deliver on his reflationary agenda as he has failed to enact any of his signature policies. Benign inflation data, softer than expected growth and a conspicuous lack of wage growth has led markets to price a reduced probability of further Fed hikes this year.

It is worth remembering that modest inflation is occurring in an environment where bond yields are still low and the threat of monetary policy being used to combat high inflation is diminishing. Assuming an inflation rate of 1.9 per cent, a 2.3 per cent treasury yield equates to an inflation-adjusted or ‘real’ yield of just 0.4 per cent. In other words, investors who want to protect the real value of their investment have little room for error.

In the UK, inflation data is far from benign, and while producer prices may be rolling over (and could give us a lead indicator of what may happen to consumer prices), the reality is that both RPI and CPI are at elevated levels; almost singularly due to the fall in sterling just over a year ago.

Crucially, the impact of inflation on consumers is often lagged because companies are sometimes reluctant to pass on price rises to consumers immediately due to fear of losing market share. Moreover, many big ticket items in the UK, such as rail season tickets, are linked to RPI and not CPI (RPI typically runs one percentage point above CPI); once again, these price hikes tend to be implemented with a lag. It is not impossible that items linked to RPI could see prices rises of 3 per cent or more in the coming months.

The inflation picture in the UK is very different to that prevailing in markets such as Japan or Europe, where central banks are a long way from achieving inflation targets. The type of inflation we are seeing here in the UK is import cost inflation, rather than the preferred ‘good’ inflation of wages growing and consumers spending more, which in turn causes prices to rise. It is also worth remembering that an individual’s personal inflation rate may be very different to the bald RPI or CPI stats – house prices in particular have hugely outstripped inflation in recent years.

Investors worried about inflation can hedge some of their risk with high-quality inflation-linked bonds. Here the principal and coupon is linked to an inflation index, meaning the capital and interest payments also increase as inflation rises. However, they also tend to be long duration assets (particularly in the UK, with a duration of around 23 years according to Bloomberg), which makes them very sensitive to changes in interest rates or interest rate expectations. Investors can mitigate this risk by diversifying globally; this not only reduces rate sensitivity (the duration of the global index is around 13 years iBoxx data shows) but they can also invest in areas where the real yield to maturity available is positive. If inflation doesn’t come through, inflation-linked bonds can still perform as low inflation implies low interest rates, which are helpful for long duration assets.

Thomas Wells is manager of the Smith & Williamson Global Inflation-Linked Bond fund