Not so long ago rising inflation was a consensual view; after a period of ultra-low interest rates and unprecedented amounts of stimulus from the world’s central banks, prices would surely have to trend higher.
Almost the complete opposite has happened however, with the UK consumer price index (CPI) falling to 0.5 per cent in December. At the same time the eurozone officially moved into deflation.
The reasons for this phenomenon have been well documented, ranging from a lack of bank lending growth, over capacity in the global economy, huge debt levels and the unexpected drop in the oil price – which now stands at just $48 a barrel after plummeting 50 per cent over 12 months.
Performance of index over 1yr
Source: FE Analytics
Nevertheless, though the large majority of market commentators expect inflation to remain stubbornly low, head of research at Hawksmoor Wood-Smith thinks CPI is at an inflexion point.
“It will not be long before inflation starts to rise,” Wood-Smith (pictured) said.
“The fall in oil will work its way through the annual calculations over the course of this year and unless something especially weird happens in the meantime, inflation rates will be rising sharply late this year and in early 2016.”
He added: “Growth will be higher, from both lower energy costs and European QE, inflation will be higher and banks will be ‘behind the curve’. For the first time since, 2007 I am convinced interest rates need to rise.”
Wood-Smith says it is dangerous to assume deflation is on the cards as it will most likely result in interest rates staying at ultra-low levels.
He is very critical about the Bank of England’s change in tune regarding future monetary policy, warning that their dovish views will hurt investors in the long-run.
“Do you remember Mark Carney’s comments about interest rate policy at the start of the oil price bonanza? To jog your memory, he said that the MPC would look through any short term effects on inflation (or deflation now) and would not be swayed by short-term swings in non-core items,” he explained.
“The minutes of the last MPC meeting showed a reversion to a 9-0 vote in favour of no change. That looks like a sway to me.”
“It is logical to believe this makes sense. I am going to argue the opposite. Growth is not going to increase until we escape from the zero interest rate mindset and we need higher, not lower rates. Zero interest rates and excessive publicity for (as yet non-existent) deflation are creating a psyche that discourages risk-taking; a near zero return appears to be acceptable.”
Nevertheless, the large majority of experts aren’t factoring in a hike in inflation or interest rates in the short-term. Many believe bonds look attractive as a result, despite the very low yields on offer.
According to FE Analytics, the average fund in the IA UK Gilts sector is up 17.71 per cent over one year, compared to a 4.55 per cent rise in the FTSE All Share.
Performance of sector versus index over 1yr
Source: FE Analytics
Though 10 year gilts now yield just 1.48 per cent, the likes of Canaccord Genuity’s Justin Oliver have said they will continue to perform well as the likelihood of an inflation-shock induced rate rise is very low.
“You have to remember, what is inflation? Inflation is where you get demand exceeding supply but the fact is that we haven’t got excess demand at the moment, that’s what commodity prices are probably signalling,” Oliver said.
However, John Ventre – who heads up Old Mutual’s fund of funds range – says that the recent rally in bonds has only been driven by changing inflation expectations.
He says the market is wrong in that respect, reiterating Wood-Smith’s view that recent inflation numbers have been skewed by an unprecedented and unsustainable crash in the price of oil. $48 a barrel and therefore there is little chance that they get the same disinflation benefits of 2014.
He argues that the fall in inflation “doesn’t make sense”, even though the oil price has plummeted, as labour markets are tightening in the UK and US.
Ventre (pictured) is a firm believer in the ‘Phillips Curve’, which suggests that inflation and the unemployment rate are inextricably linked. If jobs are plentiful then wages have to rise, he says, which will in-turn cause an inflationary impulse.
“When we put the fall in inflation expectations next to the fall in the unemployment rate next to it, they just don’t make sense together. What we believe is that the US Federal Reserve is already a long way behind the curve they should have been raising rates already,” he said.
“This lower oil price has notionally bought them time to push those rate rises out later in the year, but that is a mistake because the Fed shouldn’t be concentrating on this year’s inflation number but long run inflation expectations.”
Psigma’s Tom Becket recently told FE Trustnet that investors should look to up their exposure to inflation hedging assets as prices are currently cheap.
Investors who want to hedge their portfolios could buy assets such as index-linked bond funds, equities or physical gold themselves, though they may want to look for multi-asset funds which are already positioned for that outcome.
One of FE’s favoured in that space is £3bn CF Ruffer Total Return fund, which sits on the FE Select 100 and is headed up by the FE Alpha Manager duo of David Ballance and Steve Russell.
The managers currently holds 40 per cent of their portfolio in various index-linked bonds, 48 per cent in global equities – their largest regional bet is Japan – and a further 4 per cent gold and gold equities as a result of their long-standing view that inflation will inevitably rise.
According to FE Analytics, it has been the best performing IA Mixed Investment 20%-60% portfolio since Ballance and Russell took charge in October 2006. It has returned 94.06 per cent over that time, beating its composite benchmark – 50/50 split FTSE All Share and FTSE British Government All Stocks index – by 30 percentage points.
Performance of fund vs sector and benchmark since Oct 2006
Source: FE Analytics
Our data shows CF Ruffer Total Return has also been the best performer in the sector for its Sharpe ratio – which calculates risk adjusted returns – and maximum drawdown – which measures the most an investor would have lost if they had bought and sold at the worst possible times – over that period.
Ongoing charges figure is 1.03 per cent. Russell told FE Trustnet last year that he saw inflation as the single biggest risk to investors over the medium to long-term.
