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Is inflation on the horizon?

With more talk on the future of inflation, we asked two expert fund managers what they think.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Inflation’s a measure of how much prices have gone up over time. It’s the rate cash becomes less valuable – £1 this year will get you further than £1 next year. The Consumer Price Index (CPI) is what we use to measure inflation. CPI rose 0.7% in the 12 months to January 2021, up from 0.6% to December 2020. This is some way off the 2% target set for the Bank of England by the government.

If inflation is too high or it moves around a lot, it’s hard for businesses to set the right prices and for people to plan their spending. But if inflation is too low, or even negative, then some people might put off spending because they expect prices to fall.

In recent years inflation has been elusive. But some think it could be on its way back after the huge spending packages from governments and central banks around the world to help stimulate their economies.

Last year, to help boost the UK economy, the Bank of England cut interest rates to just 0.1% – the lowest level in its 325-year history.

Quantitative easing has been a prominent policy of theirs too. This is where the Bank of England creates new money to buy government and corporate bonds in the open market. The idea is to support the price of bonds and thereby reduce interest rates, because yields fall as prices rise. But if we were to see meaningful and sustained rises in inflation, the central bank at some point would be forced to increase interest rates.

This article isn’t personal advice. If you’re not sure an investment is right for you, please seek advice.

Why does inflation matter for investors?

The level of inflation has important implications for investors. After all, the aim of every investor is to beat inflation – to make your money worth more than what it would’ve been if you hadn’t invested it. If for example your investment grows 5% over a year and inflation is at 2%, then you’ve beaten inflation and made a ‘real’ return of 3%. Remember though all investments can fall as well as rise in value – you could get back less than you invest.

While inflation can be good for stock markets – it normally means the economy is growing – too much of it can also be an investor’s nemesis. If it gets too high, the Bank of England might raise the interest rate to make borrowing more expensive – this helps reduce the overall level of spending (inflation). This can have further implications though.

If interest rates rise, it would affect the discount rate used in lots of valuation calculations.

One common way to value investments is by taking the present value of future cash flows. This method considers the cash flows you expect to receive in the future and discounts them back to today. In this calculation, the interest rate is often used as the discount rate. And the lower the discount rate, the more future cash flows are worth and the higher value the investment has today.

This is one of the reasons the fixed income sector has performed well. When inflation is low, the value of future bond payments isn’t eroded as much – the price of the bond is more robust.

What do the bond experts think?

We know this is a topic investors are spending a lot of time thinking about, so we asked two bond experts where they think inflation could be heading.

Jim Leaviss, lead manager of the M&G Global Macro Bond fund

There are powerful forces which have been keeping inflation low for decades like globalization, aging populations and technology. So you've got to be confident that something is very different in the global economy before getting too worried about inflation. That said, something has changed.

The world’s seen record stimulus, and it’s far more concerted than in previous cycles. This time really is different: governments and central banks are pursuing expansionary policies together more blatantly than ever. So it’s likely we can expect a fairly significant rebound in demand in 2021 given that many households are in a reasonably strong financial position (though many are not) with pent up demand. In the shorter term, there will also be some base effects from low commodity prices in 2020 and shipping container shortages. Looking ahead, the US minimum wage and rising global food prices are inflationary too.

If inflation picks up, I think central banks will be far more hesitant in tightening financial conditions than we’re used to. The Fed have moved from targeting 2% inflation to targeting a long-run average, giving them freedom to allow inflation to run a little higher after a period of lower inflation. And, with government debt at near record levels, there’s a clear incentive to keep short term rates anchored down.

The big question though is the extent to which long-term damage has been done to the economy. Is the assumption that the many unemployed and on furlough will walk back into their jobs well-founded? Or did 2020 accelerate an already-changing economy and lead to the permanent decline of certain sectors and ways of working that will lead to far lower price competition in cities? My concern is that we may see more hysteresis in the economy than the market is pricing in.

Ariel Bezalel, manager of Jupiter Strategic Bond fund

My view is that the reflation trade proponents may have gotten ahead of themselves and that we will remain in a low-interest-rates-for-longer environment.

While there will undoubtedly be a spike in inflation once economies reopen due to starting off from such a low base, I expect this will fade after a few quarters as growth eventually disappoints again. Structural inflation everywhere is being kept in check by the combined drivers of too much debt, ageing demographics, and technological disruption. Even China, whose economy has been booming for a few months now, has not seen an associated pick-up in inflation.

I don’t think we’ll see much productivity payback from government spending in the last year given it’s been more about life support rather than stimulus. There’s a lot of talk about pent-up consumer demand and while some will rush back to the shops and jump on planes again, I suspect many won’t. It is durable goods purchases that drive the economy and over the last year there’s been a durable goods boom that’s unlikely to be repeated. Also, those who got caught out last year in terms of too little savings won’t want to repeat that mistake again, particularly given weak wage growth, which has been exacerbated by high unemployment levels caused by the pandemic. There is a strong case to be made that the savings rate may be elevated for some time to come.

When everyone sits on the same side of the boat, even a small cross-current can capsize the boat.

What should investors do?

Whatever you think will happen to inflation and any subsequent knock on effects, it’s important to build a well-diversified portfolio. This should include different asset classes and a range of funds with managers who have different approaches and investing styles, including value as well as growth investment philosophies.

Growth vs Value investing – what’s the difference?

This should improve the resilience of your portfolio as the economy changes and better investors’ chances of performing well over the long run and achieving their goals.

How to build an investment portfolio

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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