While the common view had been that the ultra-low interest rate environment as well as huge amounts of money printing from the world central banks would inevitably lead to the general increase in the price of goods and services, the US, UK and eurozone economies have witnessed a period of disinflation. For instance, the UK’s consumer price index (CPI) fell to below 2 per cent earlier this year.
Performance of index over 1yr
Source: FE Analytics
However, Alastair Mundy (pictured), says that he expects inflation to pick up.
“Our belief is that the result of a deflationary world is that you become inflationary,” Mundy said. “Central bankers are so keen to avoid deflation that they will create too much inflation, because these things are so difficult to fine tune. If they do ultimately create inflation, which of course you can if you do anything to excess, we’d rather hold index linkers because that gives you the ultimate protection.”
Mundy added: “It’s a long held view and inflation clearly hasn’t reared its ugly head yet, but that doesn’t mean it isn’t going to.”
Mundy holds more than 16 per cent of his £2.8bn Investec Cautious Managed fund in index linked government bonds. He admits that it may look a strange allocation, given recent developments, but it isn’t something he is going to change.
Star manager Peter Spiller (pictured) holds more than 30 per cent of his highly popular Capital Gearing trust in index-linked government bonds. Spiller says while he doesn’t expect inflation to feed through into the economy over the next year, he says it is an inevitable outcome.
“It [inflation] is a medium term event,” Spiller said. “We do think that inflation is going to come back, but there are some very powerful forces offsetting it at the moment like the strength of sterling, industrial commodity prices and food prices due to the excess capacity in the supermarket industry.”
“Also, given where we are in the electoral cycle, government is always going to be keen to keep the cost of living down, and therefore inflation, in the run up to an election. However, we think all these factors are temporary.”
Spiller says the relatively low prices of goods, which has been reflective of the slowness of the UK’s economic growth, has kept inflation at bay. While he thinks that will pick up in time, he expects services inflation to feed through far more quickly as he says the wages cycle has turned.
“Before nine months ago or so, there was this belief that we are all in this together. Employers explained that rather than firing people, everyone would have their wages cut. That has changed, however,” Spiller said.
“The wage cycle has already begun to change as the data to suggest that wages have already started to increase which will feed into rents, which have also been suppressed. When incomes go up, so will rents.”
On top of that, Spiller says that sterling is now toppy and expects it to weaken over time, which he says will give inflation another push.
The manager also completely agrees with Mundy’s belief that the world’s central banks will have a very difficult time fine tuning their ability to fend of deflation without causing excessive inflation.
“The monetary background is quite astonishing. The scale of money printing that has happened, and is still happening, is just extraordinary,” Spiller said. “There is always going to be a lag with this sort of thing, however the problem is that when it [inflation] comes, there is probably going to be a lot of it.”
Sebastian Lyon also holds a decent chunk of his Personal Assets Trust in index-linked bonds and gold as he wants to protect his investors from the threat inflation; something, he recently told FE Trustnet, he thinks is inevitable.
“Ultimately inflation will arrive. Japan and the US are monetarising 70 per cent of their issuance, something that wouldn’t have been considered five or six years ago,” Lyon said.
The team at Ruffer also sit in the inflation, rather than deflation, camp.
FE Alpha Manager Steve Russell told Trustnet last year that as the world’s central bankers have “fought tooth and nail” to combat deflation over recent years they will continue to keep monetary policy extremely loose until those pressures subside.
However, the significant inflation hedging in Mundy, Lyon and Russell’s portfolios has contributed to all three of the managers’ recent underperformance.
While our data shows Capital Gearing had delivered a positive return in each calendar year between 2000 and 2012, the closed-ended fund lost money last year. Though a widening discount was the primary driver of those losses, Spiller’s positioning meant that the trust’s NAV only returned 0.91 per cent in last year’s rising market.
Spiller says he is keeping his exposure to index-linkers because he sees it as one of the safest ways to hedge equity market risk, which he feels is very high at the moment given where valuations are.
Performance of fund and trusts vs index over 1yr
Source: FE Analytics
Investec Cautious Managed, Personal Assets and Ruffer Total Return have all seen relatively weak performance over the past year as well, with index-linkers being a drag on performance.
Performance of trust vs sector in 2013
Source: FE Analytics
A number of industry experts, such as FE Alpha Managers John Pattullo and Jenna Barnard, say that the threat of inflation has been massively overhyped as there is still excess capacity in the global economy and as there is no bank lending growth to increase the velocity of money.
Due to the relative meagre returns of inflation-hedging assets and as inflation has been coming down in the western world, some say those sitting in the inflation camp need to re-asses their position.
“In our view, most models of inflation are not working and have not done so for some time,” David Fishwick, head of macro and equities investment at M&G, said.
“For example, assertions such as ‘rising oil prices will create inflation’ or ‘printing money will create inflation’ have not come to fruition, yet people are still anchored to the consensus that inflation will somehow appear on the back on growth stimulation.”
“Perhaps observers need to rethink their assumptions about the cause and effect of inflation.”
“There remains a considerable amount of ‘excess capacity’ in developed market economies. If producers increase supply, we may see economic growth, but crucially, we may also see downward pressure on prices. As such, we think growth may push inflation even lower.”
