PA ANALYSIS: Inflation fears and protection strategies

Added 5th September 2016

The strong services manufacturing data released on Monday has added fuel to worries that the Bank of England moved too hastily in August, further dividing commentators on the medium term prospects for the UK economy and the likely next move by the BoE.

PA ANALYSIS: Inflation fears and protection strategies

The data and the corresponding strengthening of the pound has also muddied the waters when it comes to inflation expectations, an area that is beginning to play a greater role in the thinking of long term investors.

As Mike Pinggera, senior multi-strategy fund manager at Sanlam FOUR pointed out on Monday, investors are not being compensated for taking a short term view as a result investment horizons are being pushed out and, in such a scenario, inflation concerns need to play a bigger role.

Complicating this view, however is the recent moves seen in some of the more traditional areas of inflation protection like inflation-linked gilts, which have performed remarkably in the past few months.

As CIO Fixed Income at AXA Investment Managers, Chris Iggo pointed out in his latest note the index-linked bond market certainly thinks UK inflation is set to rise.

“The 10-year break-even inflation rate – the difference between yields on conventional gilts and index-linked gilts – has risen to 2.6% in recent months, from a low of 2.154% at the end of February. As a result, holders of inflation-linked bonds in the UK have had a great 2016 despite the fact that inflation has remained effectively zero.

“Almost all the return has come from price (coupons are pretty skinny on linkers and accrued inflation has been low this year) with that price being driven by the decline in yields.  The demand for long dated assets in the UK in response to the BoE re-starting QE together with concerns about inflation picking up have delivered these astonishing returns. They are unlikely to be repeated,” he said.

But, he added: “For bond investors sitting on outsized returns in 2016 it is time to think about the risks. For most sectors in the fixed income market the returns have mostly been driven by both lower rates and tighter credit spreads but it is the rates part that is at the most extreme in terms of valuation, certainly in the investment grade world where the decline in underlying rates has been larger than the decline in credit spreads. Of course, any shift in the level of rates depends a lot on what central banks do and say but there is a risk that the BoE got it wrong – the UK economy is not falling apart and inflation is going to jump.”

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Geoff Candy

Group digital editor

Geoff Candy joined Portfolio Adviser as News Editor in May 2014. He has been a financial journalist and broadcaster since 2005 and, in that time has worked in both South Africa and the Netherlands, covering everything from high street retailers and construction companies to mining and insurance.

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