Facing the music

What has happened to inflation? Despite trillions of dollars of central bank intervention, and trillions of dollars of fiscal stimulus in most countries since the financial crisis, inflation remains muted, especially when compared ?with the 1970s.

It is most likely that central banks will not tolerate outright deflation and will therefore continue to stimulate developed economies through unconventional and loose monetary policy until the economic recoveries they engender are self-sustaining (notwithstanding that the evidence suggests quantitative easing has merely made the rich richer). This would have the effect of bringing down unemployment thereby putting upward pressure on wages, in theory at least.

The UK is more vulnerable to inflation as a country with a floating currency and where imports are greater than exports. Notably, even in a period of weak demand when real wages have fallen by 8.5 per cent since 2009, inflation has still remained above the Bank of England’s target rate of 2 per cent.

We believe that monetary policy will remain accommodative and that inflation will continue to run above target before monetary policy is finally tightened.

The risks of hyperinflation seem low given the weak pricing power of workers. But if, for example, public sector wage increases were to be used as a populist tool in the run-up to the 2015 general election, this would become a greater concern.

How do you prepare for such an eventuality in the UK? It is worth noting that virtually no financial asset will perform well in an environment of hyperinflation, but given that such a period would probably be accompanied by severe weakness in the currency, having a substantial portion of assets denominated in a stronger foreign currency would deliver a certain amount of protection.

In an environment of above-trend inflation – say, 3–5 per cent per annum – equities are acknowledged to have the best inflation protection of any asset class but selectivity is critical. Particular sectors, such as technology, and oil and gas, tend to perform better, as do companies that are delivering an above-inflation increase in their dividend payments.

Conventional bonds as nominal instruments are not likely to fare well in inflationary environments because of the lack of real protection (this depends on the prevailing interest rate at which the bond was bought) and are vulnerable to upward moves in interest rates.

Index-linked bonds deliver better inflation protection but, again, the price paid is critical. Until recently, investors were willing to accept a negative real rate of return of over 2 per cent per annum on some index-linked gilts.

This has been painful during the past six months as real rates have risen along with conventional bond yields as the market prices a rise in UK interest rates as soon as 2015. Where interest rates increase in an attempt to counter inflation, cash can provide some measure of a real return.

How you respond to the end of the current era of cheap money and an eventual rise in interest rates is the critical challenge all investors face and must prepare for in the coming years.

Whether this occurs because of a surge in inflation remains to be seen, but one policy is having a low allocation to conventional bonds, some exposure to index-linked bonds, a carefully chosen portfolio of equities (in particular overseas equities) and a reasonable cash weighting as protection.

Fergus Boyd is investment manager partner at Smith & Williamson

The firm writes a regular in-practice article on asset management for Private Client Adviser

This article was published in the December 2013/January 2014 issue