Inflation? Not as I know it…

Discussing inflation and interest rates at a dinner party is a sure-fire way to lose friends. For investors fighting against the tide of today’s backdrop though, it’s a topic that simply isn’t being talked about enough.

Inflation? Not as I know it…

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The market downturn last week was prompted by an unexpected spike in US wage inflation data, as well as the Monetary Policy Committee’s (MPC) hint that rate rises would need to happen sooner and on a larger scale than they first thought back in November. The inference was that this is due to inflationary concerns.

Not only this, inflation figures from the US this week were also far higher than anticipated, having risen by 2.1% in January when economists were largely expecting a fall of 1.9%.

While you could indeed call this an inflationary environment, we have actually seen hardly any inflation at all for years – in the grand scheme of things. In fact, the 3% inflation that we currently have could arguably be called healthy.

But what if inflation reaches 6%, or more? In the same way that many investors have become complacent about market volatility – which we’ve had hardly any of for a while until last week – my worry is that investors have become equally complacent about hyperinflation.

One of the benefits of having been around in the 1970s is that, unlike many investors today, I’ve seen inflation reach 20% (this was two years before the deep recession in 1981). I’ve seen bond yields hit 16%. Once the inflation genie escapes the bottle, it can turn the market entirely on its head.

Today, the Bank of England looks set to raise interest rates and theoretically dampen inflation, which I’m sure will provide many investors with further solace. But can we trust them to get it right, or do we need an insurance policy to protect us from central bank mistakes?

In one sense, it would actually be in the Bank of England’s best interest to encourage inflation (even though governor Mark Carney staunchly says this is not the case), because it would reduce the value of all of the outstanding debt it holds.

Meanwhile, a gradual rise in interest rates (perhaps counter-intuitively) could be beneficial for the economy. If the cost of borrowing money were to increase, it could encourage companies to spend their money sensibly as opposed to frittering it away on share buybacks which, despite lining the pockets of shareholders, does nothing at all for the wealth of the broader economy.

On the other hand, if interest rates rise too quickly in advance of an inflationary creep-up, this could trigger a recession, although economic data looks reasonably strong so this would perhaps be a year or so down the track. It is a fine balance for the Bank of England to strike.

Of course, this is all speculation. But the fact remains: interest rates are rising, bond yields are rising, and it’s making it less attractive to hold conventional fixed income and certainly government bonds in today’s environment.

Where to invest

For those who still want to maximise asset class diversification in their portfolios through fixed income, the traditional method is to hold inflation-linked bond funds. However, the bonds held in these portfolios tend to be fairly long-dated and, as such, are more susceptible to duration risk in an interest rate-rising environment.

For investors who are particularly worried about this, Artemis Monthly Distribution – which invests in both equities and bonds – could be attractive. James Foster, who heads up the fixed income side of the portfolio, has reduced the portfolio’s duration risk significantly.

Elsewhere, Ariel Bezalel’s Jupiter Strategic Bond fund may present itself as a good, diversified option. It currently has a small weighting in floating rate notes which means that some of the portfolio is hedged against interest rate rises. Other strategic bond funds – such as Fidelity Strategic Bond – will hedge some of their portfolio through derivatives.

But, if you really think inflation is going to become a big problem over the medium term, it’s a good idea to start looking at real assets such as gold, physical property funds and infrastructure. Here, we like Blackrock Gold & General or Janus Henderson UK Property.

Ultimately, to quote Spanish philosopher George Santayana: “Those who cannot remember the past are condemned to repeat it.”

I would suggest that it’s up to those of us who have lived through a few market cycles to remind investors of the true dangers of inflation.

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