Defend yourself from the return of inflation
Oct 23, 2009
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Inflation - back before you know it.
The markets have been undecided about whether we are going to encounter a deflationary spiral or an inflationary bubble.
I expect deflationary pressure in the short term, but that inflation will trump it in the long term. It's easy to talk up the dangers of deflation because that's what's happening right now. Consumer price inflation has fallen to 1.1% in September, down from 1.6% in August. So with prices trending lower, the safe play is to go with the flow.
What this doesn't consider is that inflation expectations are actually higher in the UK than most other markets in the world. Using what are known as 'break-even rates' we can see that longer-term expectations of inflation are in fact the highest for Britain. Here are the latest break-even rates for the major economies:
Eurozone: 1.6%
Japan: -1.2%.
UK: 2.6%
US: 1.7%
This shows index-linked (inflation protected) bonds are pricing in a level of inflation significantly higher level than the rest of the developed world. Index-linked bonds pay an extra amount of yield to normal bonds. The disparity between one region and the next is equal to the difference in inflation expectations. As you can see from the figures above, the markets are being very clear right now. The UK faces the greatest inflation threat.
Why do the markets see Britain as the most inflationary major economy?
Also, how do we play this trend now that bonds are already pricing in inflation?
How the Bank of England could be engineering inflation
Relative to the size of the economy, the UK central bank has been the most committed to quantitative easing.
Specifically, equity prices have remained firm since the influence of quantitative easing (QE). The purchase of gilts by the Bank of England serves to depress gilt yields, thereby driving investors into higher yielding corporate bonds and also equities. In time, QE flooding into the economic system will provoke a more general asset price inflation. How can investors protect themselves from this threat?
QE serves to depress long-term interest rates and, at the same time, stoke up inflation concerns in the long term. Both influences will serve to undermine the pound sterling. Furthermore, the UK authorities are quietly happy with this state of affairs. A lower pound will help rebalance the UK economy towards exports at a time when the financial services industry is not the source of output, employment and tax revenue it once was.
A weaker pound will favour companies with large overseas earnings, while investors will benefit from those shares which pay dividends in dollars. This development will favour larger UK companies. In fact, 70% of profits from FTSE 100 companies come from abroad. So you could say that FTSE is more an international-based equity index than a UK one. Certainly, economic developments in the US and China are more influential for our equity market than some would imagine. Shares such as BP (LSE: BP), GlaxoSmithKline (LSE: GSK) and British American Tobacco (LSE: BATS) derive the lion's share of their earnings from overseas, while BP pays a dollar dividend.
Why it's time for defensives
So a portfolio of equities consisting of high yield, defensive overseas earners is well placed to deal with a less exciting economic recovery than is currently baked into the value of some growth stocks. Moreover, this portfolio offers protection if weakness in the pound turns into a rout.
Back in March, cyclical equities rallied to extraordinary levels. At the time, I did not quibble with the analysis and indeed found some elements persuasive, but my contrarian instinct prevented me from following the crowd. I opted for safer but equally profitable markets, finding success by investing in investment-grade corporate bonds.
The problem of the overextended consumer, precarious bank balance sheets, rising unemployment and ballooning public debt has not gone away. With such headwinds facing the recovery, it is very unlikely that growth stocks will continue to outperform defensives as they have done recently.
Accordingly I have a bias towards defensives and see no reason to re-position it in favour of growth stocks which look overextended. A handful of select defensives will do well in this climate.
• This article was written by Brian Durrant chief economist at The Fleet Street Letter newsletter, and was first published on 21 October 2009.
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