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Investment Uncovered: How to prepare for inflation changes

By Valentina Romeo

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Jun 05, 2018
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As the outlook for the UK’s economy remains uncertain, how can advisers prepare portfolios for any change in inflation? 

As higher inflation fails to appear on the horizon and wages grow faster than expected, fund managers are weighing up their portfolio moves for any potential changes in the economy.

The UK consumer prices index rose by just 2.5 per cent in March, down from 2.7 per cent in February, its lowest level in a year.

This month, the Bank of England governor Mark Carney said inflation will weaken faster than previously thought. In the meantime, fresh data from the Office for National Statistics shows that average earnings in the UK in the first quarter of the year rose 2.9 per cent from 2017, which was the fastest pace since August 2015.

Money Marketing speaks to a trio of experts to discuss what impacts the changes in inflation could mean for retail investors.

What is your outlook on inflation for the rest of the year?

HSBC Global Asset Management chief global strategist Joseph Little: UK inflation has surprised to the downside and is already back at the levels the Bank expected to be reported at the end of 2018, linked to recent movements in sterling. Given the improved labour market, wage inflation pressures should build slowly, butunderlying inflation pressures in the UK economy remain subdued.

BNY Mellon Investment Management manager of the Insight inflation-linked corporate bond fund Dave Hooker: The Bank of England estimates that the rate at which the economy can grow while maintaining balanced domestic inflationary pressure is around 1.5 per cent per annum. This is the level of growth at which the amount of spare capacity or slack within the economy is neither rising nor falling. This level of growth is commonly referred to as “potential growth”. With the UK economy growing beyond this level in recent years, the level of economic slack has reduced.

While short-term inflation has moderated more quickly than expected, the medium-term picture is deteriorating. The low level of wage growth is a conundrum given historically low unemployment levels, but the risks of more meaningful gains in wages are rising and some underlying employment data is concerning.

Spare capacity is low and with global growth performing well there is a risk that the UK economy could grow at a faster pace than forecast. If this were to occur then it is likely to stoke domestic inflationary pressures even further.

What are the impacts of low inflation on asset classes today?

Little: We have been cautious on UK equities, but we think the valuation story looks a bit better than it has done. Even so, we would still prefer “late cycle” equity markets such as continental Europe, Japan and emerging markets. The inflation environment remains subdued, but UK gilts are still expensive. We would prefer to hold treasuries in multi-asset portfolios.

For sterling, we think the balance of risks favours further sterling weakness versus the dollar, but the scope for weakness is less than it was after recent moves.

Even so, the downside forces are still there. We think a combination of valuation, relative growth and relative interest rates mean that the dollar should outperform sterling on a tactical basis.

Seven Investment Management research analyst Jack Turner: Despite the weak UK growth data, UK equities have been performing well, with the FTSE 100, and to a lesser extent the FTSE 250, buoyed by the fall in sterling. We are underweight UK large-cap equities, although closer to neutral than we have been at any other time in the past four years as Brexit-related caution from overseas investors could arguably be starting to present some value opportunities.

Hooker: Even under their current scenario the Bank’s Monetary Policy Committee expects inflation to be at 2.2 per cent over two years and still above target at 2.1 per cent over three years. For investors, it is important to remain vigilant.

Nominal yields in developed markets are likely to rise in coming years, as the European Central Bank is expected to draw its quantitative easing programme to an end and fiscal reforms in the US ramp up supply.

For UK inflation-linked bonds the technical outlook may be more attractive. Demand from pension funds continues to be strong, while there is speculation that the UK government may start to reduce inflation-linked issuance in coming years, as inflation-linked bonds represented around 28 per cent of UK debt stock at the end of 2017.

What is the outlook on inflation outside the UK?

Turner: The UK is only part of the story, and with global growth remaining strong elsewhere, inflation surprises are more likely to be on the upside than the downside.

In the US, core inflation is likely to rise above the Federal Reserve’s target in 2018, with a tight labour market and rising oil prices making three rate rises this year increasingly likely. One of the ways we are dealing with this is to hold a US inflation swap.

These strategies are designed to gain in value as inflation increases, and fall as inflation expectations decrease. While not dissimilar to an inflation-linked bond, they do not have the same sensitivities to interest rate rises. We are also underweight fixed income, a position designed to help cushion portfolios in the event of a bond sell-off.

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