Investors should be looking to protect their portfolios against rising levels of inflation, according to Neuberger Berman’s Thanos Bardas, who says that wage growth, a rising oil price and increased economic activity all mean that improving consumer price indices’ (CPIs) are on the cards.
Despite central bankers’ best efforts, inflation figures have remained stubbornly low as even after years of extraordinary monetary policies like quantitative easing and ultra-low interest rates, factors such as over-capacity in the global economy, huge levels of debt in the system and more recently the huge falls in the oil price have kept a lid on CPIs.
Performance of oil price since Jan 2014
Source: FE Analytics
This has all meant that a “global deflationary death spiral” has been most investors’ main concern over the last year or so and this is compounded by the fact that the UK inflation is expected to fall into negative territory when official figures are released tomorrow.
However Bardas, head of global rates and inflation strategies at Neuberger Berman, says investors who are positioning their portfolio for a fall in the price of general goods and services are making a major mistake.
He says that as various metrics are pointing to a turnaround in US inflation expectations, investors need to act sooner rather than later to protect their portfolios.
“US inflation remains modest to be sure. Still, we believe the seeds for an uptick have been planted, and that further shifts in inflation expectations, when they arrive, could be felt quickly,” Bardas said.
“In such an environment, we feel investors should be considering ways to manage inflation in their portfolios, whether through TIPS, or other assets such as commodities, lower-rated debt, master limited partnerships, real estate investment trusts and/or certain equity sectors, which have tended to hold up better than traditional bonds in inflationary periods.”
Bardas says there are a number of reasons for this reflationary phenomenon such as a rebound in the oil price (which is up more than 30 per cent since its trough in January), loose monetary policy in the eurozone and improving employment levels in the US.
However, like FE Alpha Manager Martin Walker and other leading industry experts, Bardas says a more powerful factor is at work – namely wage inflation, which is picking up around the developed world.
These concerns about higher inflation may come as a surprise to most, given that the UK is expected to fall in deflation when official figures are released tomorrow.
Nevertheless, Wealth Horizon chief executive Chris Williams says investors should not expect the UK CPI to stay negative for any real length of time and therefore agrees with Bardas that now is the time to buy protection.
“If the April figures do reveal that the country is deflationary, the impact is likely to be more symbolic than anything else, with inflation likely to return almost immediately. March’s figures showed signs of technical deflation, so it is possible that we will see this reflected in this month’s figures,” Williams said.
“However, the UK’s low unemployment rate is likely to support a further pick-up in pay growth and, coupled with strengthening oil prices, this is likely to mean that not only will May see the return of inflation, but over the long term we may be set to see it return to the Bank of England’s target of 2 per cent.”
He added: “Possibly as early as the first quarter of next year.”
Bardas also points out that many investors in the US are already preparing for an inflationary shock by upping their exposure to index-linked bonds.
“The potential for an uptick in inflation hasn't been lost on investors, as evidenced by increased demand for TIPS [treasury inflation protected securities] this year,” he explained. “Thus far in 2015, investors have purchased 72 per cent of all auctioned TIPS, which is the highest level since at least 2003, while more flows have been moving into ETFs that invest in TIPS.”
“These trends have been viewed by the market as a large bet on an upside surprise in inflation in the coming months.”
For those who want to buy protection, there are several funds which should hold up much better than others in an inflationary environment.
There are the likes of M&G UK Inflation-Linked Corporate Bond, Insight Inflation Linked Corporate Bond and Fidelity Global Inflation Linked Bond, which all aim to deliver total returns greater than the rate of inflation.
Another option may be to look at asset classes which would benefit from higher CPIs, such as infrastructure.
Investors can gain direct exposure to infrastructure projects via investment trusts or they could choose the likes of the five crown-rated First State Global Listed Infrastructure fund, which invests in companies involved in infrastructure around the world in sectors such as utilities, highways and railways, airports services, marine ports and services, and oil and gas storage and transportation.
According to FE Analytics, the £1.3bn fund – which is run by FE Alpha Managers Peter Meany and Andrew Greenup – has comfortably beaten the IA Global sector and the MSCI AC World Infrastructure index over six years with returns of 109.05 per cent.
Performance of fund versus sector and index over 6yrs
Source: FE Analytics
The fund, which yields 2.75 per cent and has an ongoing charges figure of 0.9 per cent, sits on the FE Select 100 and it is one of the FE Research team’s favourite choices for inflation protection.
“In the current environment, the infrastructure sector can both protect investors’ capital and act as a buffer against inflation. It also attracts income investors searching for alternative to the coupon payment offered by bond markets,” the FE Research team said.
“First State’s well-respected team of analysts have excellent knowledge of this market, which makes the group ideally positioned to take advantage of any opportunities that present themselves.”
Given the anticipation of higher inflation, the consensual view is that investors should avoid traditional fixed income such as government bonds at all costs.
As a result of improving economic data, the expectation of higher interest rates and a backlash against the ultra-low yields on offer, the prices of UK, US, German and Japanese sovereign debt have all dropped substantially over recent weeks.
Performance of indices over 1month
Source: FE Analytics
A number of experts have warned that the recent spike in yields is the beginning of a prolonged bear market in fixed interest.
“Is it the end of the bull market? Is it the start of the bear market?” Chris Iggo, chief investment officer of fixed income at AXA IM, recently told FE Trustnet.
“What I take from the recent price action is that more and more investors are avoiding negative or very low yielding bonds and more and more think that reflation is actually taking place. Bank lending in Europe is starting to increase, oil prices have stabilised and US wages are picking up.”
He added: “Inflation markets have responded to that and should continue to do so. Everyone has thought bond yields would rise at some point. Reality check – it might be now.”
John Bilton, global head of multi-asset strategy at JP Morgan, is slightly more constructive on fixed income, however.
He says that while the recent rise in yields is a wakeup call to investors who have had lazy positioning within portfolios, there are a number of reasons why bond prices may rise again in the not-too-distant future.
As a result, Bilton says we are now in “injury time” of the great bond bull market.
“With European net bond supply turning negative again over June, July and August, and inflation data remaining contained there is scope for global bond yields to drift lower once again this summer,” he said.
“But with two-way inflation risk now back into the long-end, bond bears are likely to be much more emboldened should yields drift too far. On balance, we are probably into ‘injury time’ on the great bond bull market, but pricing for a surge in inflation, or fearing stagflation, is premature.”