Protecting against inflation
New inflation figures for February show CPI inflation rose to 2.3%. That’s a hike of 0.5% in just a month and the first time the Bank of England’s 2% target has been breached since 2013.
In the Budget the Chancellor Phillip Hammond said the OBR expectations were for CPI inflation to reach 2.4% this year. We would not be surprised to see that forecast adjusted upwards. As Yellen said last week, the Fed is more likely to let inflation overshoot than undershoot targets and this may be the case for other Central Banks. Central Banks don’t want to derail the economic recovery by tightening too quickly and this particular recovery has been very long and protracted, making them arguably more nervous than usual.
A number of factors are driving inflation. The fall of sterling since the Brexit result means input prices are rising. Manufacturers have been absorbing modest inflationary pressures for several years. They cannot continue to absorb all the extra costs they are incurring and growing confidence in the economy means their tolerance for such pain is considerably reduced.
Workers are feeling more confident as well, and similarly less willing to pay higher prices without receiving more in their pay packets, so we are seeing pressure on employers to raise wages. This can soon spiral.
We don’t think it necessarily will, but if you look at the difference between the pricing of index-linked bonds and their conventional counterparts you will see that the market is pricing in expectations of 3-4% inflation and we don’t think that is inappropriate.
The protection of client assets is fundamental to our role so how do we position portfolios to protect client assets from the slow death of inflation?
A key response is to buy equities – these tend to be more positively responsive to inflation, especially if your portfolio is weighted towards companies best able to pass on rising costs with some degree of impunity. After being cautiously underweight equities for some time we are now back to neutral levels – still resisting the temptation towards excessive optimism that has been a feature of US markets since Trump’s election. We do, though, feel more confident about the global economy. Momentum remains good and the companies we meet report rising investment plans and an end to inventory de-stocking.
While some areas of the world look overpriced, we think there is still some value to be found in parts of the UK market and in Japan, for instance. In an inflationary environment we would expect movement from bonds to equities and this will drive prices higher.
We are underweight fixed income and within our fixed income portfolios we have a bias towards index-linked gilts and US treasury inflation-protected securities. We think that if there is a surprise on the upside to inflation these will outperform conventionals.
In short, today’s news is not a surprise and we have been positioning portfolios to prepare for this for some time.
Published 21 March 2017
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