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Why now is the time to inflation-proof your portfolio, according to PIMCO

25 August 2016

With inflation potentially coming back in the UK and the US, and measures to bring it back in Europe, PIMCO suggests investors look to add protection.

By Jonathan Jones,

Reporter, FE Trustnet

Central banks have been trying to stimulate inflation for more than seven years, yet it remains at stubbornly low levels despite a slew of policies around the world. 

Economic growth remains stagnant or slowly growing in a number of developed markets, with the UK, Europe and the US central banks all trying to use monetary policy to boost their economies – whether that be by introducing ultra-low (and even negative) interest rates or via quantitative easing.

However, too much debt, an aging population, and falling oil prices have all kept inflation low despite the once commonly-held view that money printing would lead to higher prices in the cost of goods and services.

The consensus now, therefore, is that investors will continue to live in a world of disinflation or even deflation.

“Persistently low growth and low inflation look like they are here to stay,” Iain Stealey, portfolio manager at JPM Global Bond Opportunities, said.

However, there are many that believe inflationary pressure could come about sooner rather than later, particularly in the UK, and the US, though for very different reasons.

Earlier this month, the Bank of England cut interest rates to an historic low 0.25 per cent sending the pound into freefall.

Relative performance of sterling in 2016

 

Source: FE Analytics

The effect of this has been to make imports more expensive, while commodity prices have also been on the rise, raising the price of goods in the UK.

Perhaps most importantly, in the US, the Federal Reserve has not yet raised interest rates this year, having raised them at the end of 2015 for the first time since 2006.

Many had expected the Fed to make four rate hikes over the course of the year, yet so far interest rates remain stationary at 0.5 per cent as the central bank has become far more global-facing in its policies.

With signs the economy is picking up including US wage growth and markets rallying, the Fed could still be tempted, but inflation remains a problem, as raising interest rates will reduce inflation in the country.

This, coupled with macro-economic issues relating to China at the start of the year, the outcome of the EU referendum, and the upcoming general election, have added to the Fed’s reluctance to raise interest rates.

The minutes of the July US Fed meeting showed a divided committee with some members thinking that the economy was sufficiently strong to weather a rate increase, while others felt that they would prefer to wait for inflation to move higher before moving.

In its mid-year update PIMCO said: “Markets are currently expecting that the Fed will fail to achieve its inflation target over the next several years, which in our view is unlikely.”



Indeed, PIMCO says that inflation will continue to tick up over the coming years.

“While core CPI (Consumer Price Index) is already close to the Fed’s target, we believe headline CPI will be there too by early 2017.”

“Furthermore, long-term trends like the rise of populism, the reversal of globalisation, moderation in the US dollar appreciation and the possibility of fiscal stimulus are likely to counter the deflationary trends of the last several years.”

Given the market is currently priced for a low rate, low growth, low inflation environment, if inflation were to tick up even at a gradual pace it could have major ramifications for both equity and bond markets, which are both trading near all-time highs.

Performance of indices in 2016

 

Source: FE Analytics

“In certain circumstances, particularly inflationary circumstances (which obviously aren’t the base case of the market at the moment but these things can change very quickly), then any bond or bond proxy will be the most dangerous place to be,” FE Alpha Manager Ben Leyland said in a recent FE Trustnet article.

As such, PIMCO says now is the perfect time to buy inflation-protection with portfolios – not only to make money in such an inflationary environment, but so investors have protection when their more traditional bond and equity holdings inevitably take a hit. 

As a result, the group has become increasingly positive on Treasury Inflation Protected Securities (TIPS).

“In this environment, TIPS seem undervalued and particularly attractive as they embed many of the defensive aspects of high quality government bonds.”

“We believe US TIPS are an attractive stand-in for defensive high quality government bonds given low levels of inflation expectations and remain attractive in a world where inflation expectations are poised for a rebound.”



For investors in the UK looking to add similar inflation protection to their portfolios, Square Mile Research suggests M&G UK Inflation Linked Corporate Bond fund.

“This is an interesting strategy which should provide investors with protection against UK inflation over the longer term, whilst offering something slightly different from standard government inflation linked bond mandates” it said.

The £680m fund, run by Ben Lord and Jim Leaviss, aims to protect against the effects of inflation by investing in inflation-linked bonds issued by companies with a high credit quality.

Performance vs sector and benchmark over 5yrs

 

Source: FE Analytics

It has lagged its benchmark, as the fund’s principle aim is to beat inflation over the long-term, and over five years it has done – beating UK CPI by 3 percentage points.

“It is likely to be suitable for investors who wish to protect both the capital value and income of their investment from the effects of UK inflation and who are prepared to hold the fund for reasonable time periods (at least 5 years),” Square Mile said.

The inflation-linked bond fund, which includes a mix of corporate and government bonds, currently yields 1.4 per cent and has an ongoing charges figure of 0.66 per cent. 

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