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Investment Overview – April 2013 ‘Inflation a concern or not’ I will be keeping this month’s overview reasonably short and quite specific in its content. Over the last three/four years inflation has not been an issue that many economists have focused on. This is despite the fact that for the last two years we have seen inflation above the target of 2% set by the Bank of England and in previous years we had the ‘sceptre’ of deflation hanging over our economy. A small number of economists believe this could still happen with the stalling of growth in the UK Economy. Therefore, I felt it was important to add my views to the argument regarding inflation as this will clearly influence the structure of portfolios with regards to the fixed interest areas going forward. So what are my thoughts on inflation over the short and medium term? Well I am not normally a person who tends to ‘sit on the fence’. I am once again taking a firm stance on how I see things moving over the next 12 months as well as the three to five year position. However, I am going for the ‘middle ground’ on my thoughts of where inflation will be over those periods. ‘Middle Ground’ basically means I do not feel that we will enter or even be nearing a period like Japan of deflation, nor do I feel that we will once again experience ‘spiralling’ wage demand fuelled inflation. What I can see is that over both the shorter term and the next five year period, we will see inflation moving higher with a potential to hit 5.5% to 6% over the next two to three years, which in itself would signify quite a large increase from the current position of CPI of 2.8%. So what are the areas that will influence this increase: 1) Demographics- Currently the percentage of people over 60 in the global population is 12%. It is forecast by 2050 this percentage will have more than doubled to 26%. With a rising global birth rate and people living longer the economics are more people consuming goods and services and fewer people producing them will only mean a rise in future prices. This increase is not just limited to the Westernised economies but a global phenomenon, with increases in the aging population in the emerging economies growing at nearly twice the rate as the developed economies. 2) Food inflation- One of the biggest areas of inflation over the next five years will be seen in this area. Since 2000 we have seen a doubling of food based inflation and again this trend does not seem to be slowing down. It is this area of inflation that I see impacting over the shorter term and will have a significant impact over the next 12 months. One of the areas that could limit the impact would be the weather. With a particular horrible 18 months in term of the global weather patterns, a shift to a normal cycle of weather for a decent period of time would go along way to helping keep prices at a reasonable low level but if we experience another 12-18 month period of floods, rising temperatures and general poor weather conditions along with the increase and aging population aspects food prices and, therefore, food inflation will only continue to soar upwards. 3) Oil & Energy Prices - Tensions in the Middle East, complete lack of any alternatives to our energy consumption going forward, and a lack of control by most Governments worldwide on the Energy Companies as meant that like Food Inflation energy based inflation has spiralled upwards at an alarming level over the last 5 years. Shale Gas will provide certain areas of the Global economy especially the United States with some means of alternative energy source. However, even that may not be produced any cheaper than current Oil production, so we are all going to see continued pressure on our individual costs for our energy consumption and this again will keep inflation moving upwards. 4) Quantative Easing (QE). In the last 7 years over 10 trillion dollars has been pumped into the global economy by Central Banks around the world. To put this figure into perspective it is larger than the current combined Gross Domestic Product (GDP) of the UK, France and Germany and we know that it will not stop there with further monies being ‘fed’ into the system by Japan. Despite this level of QE we are not seeing this money floating about in the Global economy, mainly due to the fact in the westernised countries the banking world as decided to hold this cash on its balance rather than allow it to get out into the system. Until the banks feel totally secure regarding their own Balance Sheets this money will be well hidden, so I do not feel that QE will have a major impact on inflation and in the short and medium term it will be areas 1, 2 & 3 above impacting more positively on inflation than the additional monies in the system. So how will this impact on Clients Investments?. Clients have been extremely fortunate over the last five years in that despite record low interest rates, and struggling equity markets they have been able to secure positive ‘real yields’ for their Investments. For Investors using ‘Cash’ we have seen attractive offerings for Financial Institutions certainly for the Medium term investors which have regular provided a return well above the static low rates of Inflation we have seen. For those more adventurous clients, who have utilised fixed interest areas, like cash, we have seen attractive prices and yields mainly on the longer dated Gilts and Bonds which again as allowed returns at well over that needed to cover inflation. This I believe is all about to change and clients who are very reliant on Cash and Fixed Interest vehicles for their returns will start to find that not only will the options to invest in be limited but even a small rise in inflation will start to convert positive ‘real yields’ into negative ones’ and certainly with cash and Investment Grade fixed interest you may see it ‘burning a hole in your pocket’. The reason for this is twofold, firstly an increase in inflation will always have an impact on Yields however, over the last three years we have seen yields in most ‘Investment Grade Credit’ areas of Sovereign and Corporate Debt fall quite dramatically. There has been good reason for this which we all know about, however it cannot hide the fact that even a fall rise in Inflation will significantly impact on ‘Real Yields’ and the real concern I have in this area is that of any ‘Long Dated Issues’. These opportunities have provided a real positive boost for portfolios over the last two years will now start to really struggle and if you are left holding them, you could see a large correction in this area of your portfolio. The second area is the affect we will see via the ‘Banking World’ in the push to get them better prepared to deal with another 2008 banking collapse. As we have seen despite record low interest rates around the world, savers have benefited from the Banks wanting to show that they have savers interest at the ‘core of their propositions’ in fact all we have seen is the banks looking to support the saver who is comfortable with placing their money with an institution over a reasonable period of time, three, four, five years. They have used the insecurity in the equity market to ‘Market’ investments that pay a reasonable return as long as the investor will place their monies over these longer periods. Nothing wrong with that at all, investors and the Banks have benefited from real returns in offering what is to them pretty cheap options to gain the deposits. However, this is all about to change with the Banking Institutions looking very closely at the New Legislation and the impact this will have on their balance sheets. As with short term investors who have not had any benefit at all from the offering from the Banking Institutions, clients looking to invest over the longer period of time will start to see rates fall quite dramatically in fact for this new ISA season will have already seen a marked reductions in the ‘headline rates’ being offered even over the longer terms of 4-5 years. So coupled with a rise in Inflation clients with large cash holding whether this is secured on a short medium or longer term basis could see ‘Negative Yields’ entering into their Investments and ‘burning a hole in their pockets’ So how can an investor protect themselves from Higher Inflation? As with all investment areas where there is a potential negative there will always be a potential positive, how the negatives and positive evolve and then impact will always be different and, therefore, it is very important that the economic circumstances we are facing are being well monitored with a strategy to deal with it being put into place as soon as possible. The reason I am saying this is because most of the media is now starting to ‘pick up’ that there are inflationary pressures in the UK and Global economy and with this there will be a deluge of advice on how you should protect your savings against this ‘beast’. As with all areas of advice I would strongly recommend that you allow the people who know and understand what is happening to deal with the situation for you as it would most probably mean formulating a number of strategy’s not just one that is supposed to ‘fit all’. One of the main areas for support for the lower risk clients will be to review what they hold that as inflation proofing linked to it, this could be in the form of National Saving Investments (NSI) that have a inflation link to them, good opportunity to support your very low risk areas of your Investment holdings. However, NSI have not supported this area with a new issue for a while now despite a lot of lobbying for them to do so. In the Fixed Interest Range there is always the opportunity to link into ‘Index Linked Gilts, which provide a yield which increased with the rate of the Retail Prices Index in the UK and the Consumer Prices Index in most other developed nations economies. Always a good ‘go to option’ when we have inflation increasing, however, for this economic cycle we have a bit of ‘sting in the tail’ and conventional Index Linked bonds may not be the ‘all singing all dancing’ opportunities’ that some of the media commentators will clearly start to imply. The reason for this is something called ‘Breakeven’ rates which is the ‘spread’ between conventional gilts and Index Linked Gilts. Normally, when we start to see increased inflationary pressure, the spreads will widen giving Index Linked Gilts the opportunity to outperform its conventional Gilts partner. At this present time in the UK, US and Germany we have actually seen the breakeven position fall indicating that there is less risk from Inflation, technically that would be the right interpretation however, the real reason that the breakeven (spreads) are falling is due to the current imbalance in the conventional gilt market and the pressure being placed on long dated gilt prices, with a concerted sale of Long Dated gilts for more short dated opportunities, as the Index Linked market is based mainly around the medium to long dated areas we have seen this unusual shift in the breakeven position which will reflect over the short term on Index linked returns. What is needed now are proactive Fund Managers in this area who have a true conviction for inflation and will go into the market to ‘pick up some bargains’. The other main area for Investors will be via the diversification that can be offered through the Inflation Proofing areas. Global Inflation is a key area to link into, however, this will always come with a higher risk premium than via the UK Market because of the areas that the fund manager will be using for the fund mainly that of the emerging markets like China, India Brazil etc that currently are experiencing quite serious wage based Inflation. Also a number of funds are now looking at alternatives to the sovereign position of Index Linked, and are looking to buy into ‘Corporate Index Linked debt, this area is pretty limited in the offering’s that a Manager can buy into however, it does offer a very credible alternative to normal Index Linked issues. Finally and the easiest way to beat inflation is to utilise in your portfolio equities. Despite a very difficult 5 year period equities have continued to perform both above cash and, therefore, above inflation. A balanced portfolio with quality equity exposure that can benefit from both growth as well as dividends will to my mind always provide a far better opportunity over the medium to longer term than cash so my final message would be take a look at your cash portfolio and analysis how long you have held money in cash without taking any significant amounts out, and in most circumstances I would be 90% certain that the answer is Five years plus. If you are part of the 90% then I would strongly recommend a ‘sit down and discussion’ about these cash balances because we will be seeing higher inflation and even though we can never guarantee it, there will be strong possibility that the returns over the next five years will be better via a balanced portfolio than can be achieved through cash returns. Ian Jackson Investment Manager Sources of material Bloomberg- Department of Social and Economic affairs of the United Nations Secretariat- M&G Fund Managers.- DB Research