Investors are likely to face a serious inflation problem if the oil price rises above $50, according to Kames’ David Roberts, who warns that current central bank policies will create such an outcome at a time core government bonds are trading at “completely irrational” valuations. 
When ultra-low interest rates and quantitative easing were introduced to lift the global economy and stave of the threat of a debt-deflation spiral, the consensual view was that such extraordinary policies and added stimulus would inevitably lead to higher inflation.
However, as investors will have no doubt realised, that certainly hasn’t been the case with most market participants more worried about deflation than runaway inflation – as shown by the fact that core developed market government bonds have rallied hard over recent months.
Indeed, FE data shows that 10-year UK gilt yields – which currently stand at 1.4 per cent – have fallen some 30 per cent since June last year.
Performance of index over 1yr
Source: FE Analytics
Of course, one of the major reasons why CPIs across the developed world are so low is due to the significant drop in the oil price over the past 18 months. Nevertheless, many believe that with China’s currency devaluations, still high debt levels in the global economy and an ageing population, the threat of deflation will be present for some time to come.
However, though the US Federal Reserve opted not to raise interest rates again last week, official data shows core inflation in the US is starting rise to levels Janet Yellen and other policymakers are aiming for.
As such, Roberts – who is head of fixed income at Kames and oversees some £32bn worth of assets – warns that unless the oil price, which has rallied back to $39 a barrel, stays below $50 for the foreseeable future current central bank policies, particularly in the US and the eurozone, are liable to stoke inflation to problem levels at a time when core government bonds are trading at “completely irrational” valuations.
“Rates markets tell us all is broken,” Roberts said.
“But the fact is the state of the world isn’t as bad as it is currently made out to be. In fact, I’d rather see US Federal Reserve chair Janet Yellen raise rates and push the dollar up a little. However, in the same way the Fed had an opportunity to start raising rates in 2014 but failed to do so, I think we will be disappointed again; central banks won’t take the plunge.”
Indeed Roberts, who also co-manages the Kames Sterling Corporate Bond and Kames Strategic Bond funds, notes that US GDP grew 1.4 per cent in the Q4 last year, faster than the previously estimated 1 per cent.
At the same time, core inflation hit 2.3 per cent and headline inflation rose to 1 per cent.
Though Roberts says that no further rate rises from the Fed and continued quantitative easing from the ECB will help risk assets over the shorter term – with both bonds and equites delivering a positive return so far this year – it will create an issue further down the road.
Performance of indices in 2016
Source: FE Analytics
“Unless oil stays below $50 a barrel, we will find ourselves with a headline inflation problem,” Roberts said.
“Of course G7 markets have ignored that fact for nearly a decade, leaving many to buy core government debt at completely irrational valuations. I am happy not to be one of them.”
Roberts isn’t alone in his concerns, despite the fact that most investors are still preoccupied with the threat of deflation.
In an article last week, Eugene Philalithis - manager of the Fidelity Multi Asset Income fund - warned that faster than expected rate hikes from the Fed thanks to higher inflation is the biggest risk facing traditional income investors.
“Given market volatility, it was always unlikely that the Fed would hike in March. However, this statement was more dovish than expected with the committee’s expectations of rate rises in 2016 being lowered,” Philalithis said.
“In some ways this is good news for income investors, with a more gradual pace of tightening allowing for greater scope for the income from bonds to offset bond repricing from higher interest rates.”
“However, the risk is that the Fed is forced to raise rates faster than anticipated in order to head off raising inflation. This has picked up in recent months with core PCE [personal consumption expenditure] inflation – the Fed’s preferred measure – already above its expectation for the end of the year.”
There are a number of ways investors can protect themselves against higher inflation, but Roberts – who has considerably outperformed his peer group composite over the longer term – says one of the best ways to do it is avoid government bonds at all costs.
Performance of Roberts versus peer group composite over manager tenure
Source: FE Analytics
While higher inflation may cause investors to revamp their portfolios, the commonly held view is that gently rising prices and wages is good for the economy. However, taking a step back, Jim Wood-Smith – head of research at Hawksmoor – says one of his largest bugbears is the general wish for higher levels of inflation.
“Inflation, deflation and oil. How did it happen that inflation became desirable? It is a terrible thing, as everyone learned when we had it. Why do markets fear deflation so much and want higher inflation? It is idiotic,” he said.
“And to those who say ‘look at Japan’, I say please show me one piece of evidence that deflation stops consumers spending. A low oil price is brilliant, so bring on $20 per barrel.”
Investors can of course find funds which would limit overall portfolio volatility or even benefit from rising inflation (such as funds that have high weightings to index-linked bonds) and FE Trustnet will take a closer look at the options available if such an outcome were to happen in an article later this week.
