We think we may be approaching an inflection point where the markets start to worry more about inflation. Why are we more worried about inflation now than we were three months ago? The short answer is that policy has become more and more extreme. So let’s look at five reasons why.
Quantitative easing is now unlimited
Quantitative easing (aka "money printing") in the USA is now open-ended, so potentially unlimited. The Federal Reserve is buying $40bn of mortgage backed securities and $45bn of Treasuries per month. At an annualised rate, this amounts to a suspiciously handy 90 per cent of the 2012 Federal deficit.
Ultra low interest-rate policy is being misdirected
The US Federal Reserve has explicitly said that it will keep interest rates near zero until unemployment falls to 6.5 per cent. Even if this is a sensible target, interest rates are, in our view, the wrong tool to achieve it. What about supply-side conditions? What if more than 6.5 per cent of the American workforce is in practice unemployable in a higher value-added economy? This opens the prospect of interest rates staying too low for too long.
Everyone is trying to kill their currency
The US is not alone in engaging in wide-scale QE. Most of the major currencies have central banks that are looking to print money to, amongst other things, reduce the relative value of their currencies in an attempt to promote exports.
Japan has just redoubled its efforts. This beggar-thy-neighbour approach may work for one country, but if everyone is at it, it is doomed to failure. But it does reduce the value of paper money compared with physical goods and services. This is inflation.
The Bank of England may give up on inflation targeting
The successor to Mervyn King as governor of the Bank of England, Mark Carney, has raised the prospect of replacing the current inflation-targeting regime with a framework that aims at a nominal GDP number. We see this as a smoke-screen to allow higher inflation in a low-growth world.
Imported disinflation is over
Western consumers (and central banks) have benefited enormously from the shift in manufacturing to the emerging markets and, in particular, to China. Buying ever cheaper imported finished goods, from socks to televisions, has had a massively dampening impact on western inflation.
The benefits of this are now largely played out. Anything that could be ‘off-shored’ already has been. And more importantly, emerging markets are now seeing significant wage increases, which will result in higher prices for the end consumers.
To some extent, inflation is already with us. The Bank of England has exceeded the middle of its target inflation range for 38 months in a row.
What is remarkable is that despite this persistent inflation, the UK gilt market is trading at such low yields. Real interest rates on bonds have been negative for some time.
Are low gilt yields telling us that the bond markets are relaxed about the inflation numbers? Or is it rather that the same target-busting Bank of England has been the most enormous buyer of gilts and has successfully subverted all price signals?
The Bank of England now owns about one-third of the entire stock of gilts. Also pension funds, insurance companies and commercial banks have all been forced buyers of gilts, largely irrespective of price.
As a result of this, the Psigma Income fund is adopting a "barbell" strategy.
On one end of the barbell, we hold defensive, high-yielding equities that we think will be upwardly re-rated in a low-growth world. These stocks will also fare well if inflation is more prevalent because they tend to have good pricing power.
Almost half of the Psigma Income fund is invested in these areas of the market. This includes the core areas of tobacco, utilities, telecoms and food. What is differentiating for the PSigma Income fund is that within this end of the barbell, we have 16 per cent in the pharmaceutical sector, compared with an index weight of 6.8 per cent, making this our biggest overweight by some distance.
The other end of the barbell is that we hold nearly a quarter of the fund in commodities, especially oil & gas which, as well as providing good dividend income, should perform well as the risk of increased inflation becomes more wide-spread.
The £377m Psigma Income fund is currently yielding 4.19 per cent. It has lost 3.59 per cent since its launch, underperforming both its IMA UK Equity Income sector and FTSE All Share benchmark, which have delivered 8.8 per cent and 17.92 per cent respectively.
Mott’s longer-term record is much better though; since the beginning of 2000, he has returned 37.63 per cent, beating his peer group composite by 35 percentage points. He previously headed up the Premier Income and Premier UK Mid 250 funds.