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Is now the time to look at inflation protection?

24 May 2017

Dave Hooker, manager of Insight Inflation-linked Corporate Bond, explains why inflation in the UK could be here for some time.

By Jonathan Jones,

Reporter, FE Trustnet

Inflation protection has been neglected in recent years as deflation has been of greater concern to investors, but with inflation starting to pick up, Insight’s Dave Hooker warns that the stance should be revisited.

The main driver of UK inflation over the past 18 months has been the fall in sterling which occurred following the result of the EU referendum in June 2016.

Sterling has remained at low levels and, since the start of 2016, is down by 11.88 per cent against the US dollar. Although it has bounced back slightly from lows at the start of the year.

Performance of sterling vs dollar since start 2016

 

Source: FE Analytics

Hooker, who runs the Insight Inflation-linked Corporate Bond fund, said this fall in sterling has had such a profound effect because the UK is a ‘small open economy’ – a price taker – with imports of goods & services representing around 30 per cent of its GDP.

This change in the currency was paired with a rising oil prices, which bounced back from record lows experienced during 2015 and contributed to inflation rising.

However, these factors are not immediately felt in the headline inflation figures, which Hooker said have taken around 12 months to appear.

While these factors have driven inflation this year, as reflected by the recent surge in the consumer price index (CPI) rate to 2.7 per cent, they will not maintain inflation over the long term.

“How much inflation we are going to get isn’t just about what’s happening with the foreign exchange market because it was a relative price shock; it’s a one off price move and unless sterling falls again the following year you are not going to get the same effects every year,” Hooker said.

“So the amount of inflation we will see moving forward relies on the second-round indirect effects and here the outlook is much more uncertain.”

BofE inflation expectations in February 2017

 

Source: Bank of England inflation report

In February, the Bank of England forecast that inflation could range anywhere between 0-5 per cent by the end of the year but by year three of its forecast should fall, as the above graph shows.


“The Bank of England is broadly saying they do not think there will be any second round effects at all. The inflation you see at the moment is currency and energy related and once that is taken out of the annual comparison inflation will subside back to target,” Hooker said.

“And that is their justification for not raising interest rates; so far the story is pretty simple.”

However, more recently, the Bank of England has begun to suggest second round effects could take place, the manager said.

“The second round effects we are talking about for example is if a company sees its input costs increase it can either absorb that into its margins or it can try and raise prices,” he noted.

“The act of raising prices is a second round effect. Similarly if you go into your local supermarket and you see that the price of apples have gone up, that is a deterioration of living standards as you can buy less apples than you could a year ago.

The manager said: “If you’re lucky enough you may be able to go to your boss and ask for a pay rise and if you’re really lucky they’ll give you one.

“That again is a second round effect as higher wages will again mean higher costs for someone and higher inflation in the future.”

In the May 2017 inflation report, similar to February’s, the Bank of England is forecasting a 0-5 per cent band for inflation, but the key change is at year three – as highlighted by the chart.

BofE inflation expectations in May 2017

 

Source: Bank of England inflation report

“In February [year three] is downward sloping but in May it is now upward sloping and if there is an upward sloping third-year profile then surely that’s when all the transitory (energy and foreign currency) effects have fallen out of the profile,” the manager said.

“So when we look into the details they have revised up their forecast for wage growth. Now wages are a second round effect so in their forecast they are now saying there are some second round effects but monetary policy remains unchanged.

“That to me tells you that the central bank is much less focused on inflation targeting these days and is much more focused on risk management.”

Hooker said: “If you look at their research you gain a perception that they are much more worried about the downside risks of deflation – especially when interest rates are so low – than worrying about dealing with higher inflation.


“That’s very different from what the Bank of England should be doing and it has serious implications for investors – particularly those in bonds.

“The way that an investor can protect themselves from that is by holding an asset class that direct linkage to inflation in which case its inflation-linked bonds.

“We think inflation-linked bonds should form part of an investor’s portfolio partly because of what the Bank is doing and partly because of the corrosive impact of inflation.”

As such, it would be prudent for investors to up their exposure to inflation protection, which through his own study shows is particularly lacking in the average portfolio, Hooker said.

Indeed, the average investor’s portfolios has only a 16 per cent weighting to fixed income, with just 3.5 per cent of that held in inflation-linked bonds.

Since launching in February 2013, Hooker’s fund has returned 19.36 per cent to investors, slightly behind the 20.45 per cent return for the average IA Sterling Strategic Bond sector fund.

Performance of fund vs sector and inflation since launch

 

Source: FE Analytics

The fund uses derivatives to gain the inflation part of its portfolio while investing in traditional corporate bonds rather than inflation-linked bonds specifically.

“There’s very little raw material for us as an active manager to get hold of [in the inflation-linked sector],” the manager said.

In fact, the £40bn inflation-linked bond market is dwarfed by the size of the £551bn traditional corporate bonds sector. Hooker said more than half of inflation-linked bonds are issued by National Rail – a government-backed entity – with rates similar to inflation-linked gilts.

He explained: “So simply we can’t make a diversified corporate bond portfolio, so we use the traditional corporate bond market and synthesise an asset so that it gives you the investment characteristics of a corporate inflation-linked cash bond.”

The £46.3m fund has a yield of 2.3 per cent and a clean ongoing charges figure (OCF) of 0.74 per cent.

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