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Inflation ‘could hit 3% next year’ – how to protect your portfolio

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Written by: Adam Lewis
23/09/2016
Despite remaining at 0.6% in August, UK investors are being warned to prepare themselves for a ramp up in inflation.

Jonathan Baltora, who manages the AXA WF Global Inflation Short Duration fund, says a combination of the fall in the value of the pound post Brexit, and a stabilisation in oil prices should result in upward inflation surprises next year.

Inflation in the UK, as measured by the Consumer Prices Index (CPI), has stood below the Bank of England’s target of 2% for 32 consecutive months. However, Baltora says that assuming oil prices stay steady, at a level of between $40-50 a barrel, inflation in the UK could hit 3% by next year.

Baltora is not the only expert who thinks rising inflation in the UK is on the horizon. Analysts at Investec expect the headline rate to peak “a little above” 2.5% in the second half of 2017.

Why is this important?

Firstly, there is the long-term eroding effect that inflation can have on your money. The school of thinking goes that 1% of inflation halves the value of your money after 72 years – it’s called the Rule of 72. If there is 2% inflation, the BOE’s and most other global central bank’s target, it will halve the value of your money after 36 years. If inflation however hits 4%, it could erode your capital in just 16 years.

The danger is, with inflation being so low, for so long, many investors have forgotten that it was not long ago that 4% inflation was not that unusual.

“The market expects less inflation over the next decade than what we expect for next year,” says Baltora. “You may think it isn’t an incredibly high inflation scenario and you’re right. In a nutshell we expect inflation to be close to Central Banks targets globally. Those economies that tend to have a current account deficit would experience relatively more (US, UK) and those with a positive current account balance would experience less (Euro area, Japan).”

How can you protect your money against rising inflation?

Fear not, there are funds out there with the specific aim of not only protection you against rising inflation, but also allowing you to make money from it.

Victoria Hasler, head of investment research at Square Mile Consulting, says: “Whilst there are many investments which could, arguably, offer some form of protection from the potentially ravishing effects of inflation over the long term, there is only one which offers a real hedge against inflation: inflation linked bonds.”

An inflation-linked bond is a bond whose payments are indexed to the rate of inflation. A short duration bond is one with a short time to maturity, which in the sterling market is defined as a bond maturing within the next five years. A bond’s duration is a measure of how sensitive its price is to a given change in interest rates. The price of a bond with a shorter duration will be less impacted by a rise or fall in interest rates than the price of a bond with a longer duration.

Hasler says: “There are many funds which use these bonds to protect against inflation, although the downside of many of these, particularly in such a low yield world, is that they carry a lot of interest rate risk. This can, particularly over shorter time periods, dominate returns and, all else equal, one would expect the prices of such funds to fall as interest rates rise. It is interesting therefore that there have been some strategies launched in the last few years which look to reduce interest rate risk whilst still providing protection against inflation.”

So what are the other pros and cons of inflation-linked bonds?

Adrian Lowcock, investment director at Architas, says inflation-linked bonds are useful as long term investments where you have a known liability such as pension income payments and want to ensure you have the money to pay that out in the future. So they protect against long term inflation.

However while the income payments of inflation-linked bonds are linked to changes to inflation, he says the underlying prices move to reflect inflation and interest rate expectations.

“So arguably the market has already moved to reflect the anticipated inflation in the UK due to the weaker pound,” he says. “In addition, in the UK inflation-linked bonds tend to be longer dated, which makes them very vulnerable to changes in interest rates, so should rates rise investors could lose a lot of capital.”

For Lowcock, given the low interest rate environment at present, the biggest challenge is for investors to get a decent yield on them. In addition the costs charged by active managers will significantly eat into any income and, at present erode, any benefit.

For those who do want to access these type of funds, they can be bought either through your broker/adviser or direct. Or alternatively, Lowcock would suggest a passive approach such as the BlackRock CIF Index Linked Gilt Tracker.

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