A number of fund managers and strategists have voiced concerns that current artificially low interest rates and asset purchases from the likes of the Fed will eventually lead to higher inflation.
However, latest figures suggest that the European economy faces the possibility of deflation while the UK and US have been through a period of disinflation, with inflation in the UK falling to 2 per cent earlier this year.
Performance of index over 1yr
Source: FE Analytics
Pattullo and Barnard, managers of the Henderson Strategic Bond fund, say that a lot of investors have a naïve view about inflation, because although the authorities are pursuing pro-inflationary policies, the velocity of money is still too muted to trigger higher prices.
“There is a classic slide that a lot of managers were using showing the balance sheet of central banks going up with QE and they say that equals inflation. Over the last four years I have seen that multiple times,” Barnard (pictured) said.“It doesn't lead to inflation. You need commercial banks to start lending and increasing the velocity of money. That will be the trigger, but at the moment we aren’t seeing any pick-up in bank lending growth in the US or Europe,” she added.
Pattullo says that the main proponents of the inflation argument are the people who lived through the great inflation of the 1970s when an oil crisis in the Middle East and ultra-loose monetary policy in the US caused the cost of living to spike.
They believe that history will repeat itself, Pattullo says, but at the same time are ignoring the significant challenges facing the economy.
“If anything, we see a world lacking demand, especially with China and Asia being less strong. We already had excess capacity so we see a world of excess supply continuing, which is of course deflationary.”
“I think it is a generational thing. I think people older than me, and I'm 43, are used to inflation, wage pressure and excess demand in the Keynesian sense, while people younger than me are generally much more accepting that there is plenty of supply, no wage pricing pressure and are used to prices falling in the shops.”
“It’s people older than me that are writing that it’s all going to end in tears with inflation, whereas younger people are wondering, what inflation? I don't know inflation, all I know is high unemployment and I haven't got any wage price power, so where is all this inflation going to come from?”
Trevor Greetham told FE Trustnet earlier this year that there is an output gap in the global economy and that global GDP can grow at 3 per cent, either 3 per cent in one year or 1 per cent over three years, before inflation is triggered.
Pattullo and Barnard say they now sit more in the deflationist camp due to the excess capacity in the economy and because the central banks’ attempts to bring about higher inflation have not been successful so far.
“America has structurally very low inflation, the UK's inflation has gone lower and Europe's is frighteningly low. Draghi is talking about cutting rates, but does that encourage people to borrow more money? The answer is currently no,” Pattullo said.
“'Have some free money', 'no I don’t really want it because I don't think my house price is going up and why should I buy a plasma TV today when it is going to be cheaper tomorrow?'”
There are a number of notable fund managers who disagree with Pattullo and Barnard’s view. For example, Investec’s Alastair Mundy has a chunky weighting to gold bullion, gold miners and index linked bonds in his Investec Cautious Managed fund because he says QE will lead to higher inflation and therefore wants to hedge against it.
He told FE Trustnet last year that investors are wrong to trust central bankers’ abilities to effectively control inflation and wean the market off the huge amounts of stimulus without any issues.
“Central banks appear to have extraordinary confidence (or at least they pretend to) in their ability to control inflation and control the exit strategy from quantitative easing. There is no proof whatsoever that they’ve got those abilities,” Mundy said.
“To analogise, in the old days when you pressed ‘page down’ on the computer, nothing happened and then eventually the function kicked in and would leave you on row 10,000.”
Performance of gold vs index over 3yrs
Source: FE Analytics
Sebastian Lyon also told FE Trustnet last week that he is maintaining a high weighting to gold, because even though the price of the precious metal has performed very poorly over the past year, he says it will be the best asset to hold when inflation inevitably bites.
Barnard and Pattullo sympathise with Lyon and Mundy's views, but say the managers who are building in inflation protection now are making a big mistake.
“I think on a 10-year view that is probably fair; the problem is, you will lose a lot of money in the meantime. These shorts aren't free, you are paying away income,” Barnard said.
“You need to look at inflation from a long-term perspective, the spike we got in the 70s and 80s you could argue is an anomaly. If you look back at the 19th century and the early 20th right into the 50s and 60s, there were prolonged periods of very low moderate inflation like we have today. So you are betting on an outcome that is quite unusual in the context of things.”
“But obviously a lot of people remember the 70s and 80s because that was the period when they were growing up or at university,” she added.
Pattullo has managed the now £1bn Henderson Strategic Bond fund since October 1999, with Barnard joining him as co-manager in January 2006.
According to FE Analytics, the fund sits firmly in the top quartile of the IMA Sterling Strategic Bond sector since this time, with returns of 53.56 per cent, beating the sector average by more than 13 percentage points.
Performance of fund vs sector since Jan 2006
Source: FE Analytics
It has also beaten the sector over one and five years, though it has underperformed over three years due to its bottom-quartile returns in 2011.
Henderson Strategic Bond has a yield of 5.8 per cent, which is helped by its 54.6 per cent weighting to high yield corporate credit.
However, the managers are also much more optimistic on government bonds and investment grade credit than they were last year, which partly reflects their thoughts on inflation.
However, the two asset classes only make up a small proportion of the portfolio.
The fund has an ongoing charges figure (OCF) of 1.45 per cent and it requires a minimum investment of £1,000.
Click here to learn more about bonds, with the FE Trustnet guide to fixed interest.