Global Inflation - Linked

Managing the risk of inflation
 
After two years of unprecedented monetary stimulus, inflation remains a key unknown facing investors into 2010 and beyond. While there are many solutions across asset classes to hedge against rising inflation, within fixed income most have been confined to inflation-linked Gilts. However, a global portfolio of inflation linked bonds can offer a better and more cost-effective means to hedge against the growing inflation risk facing UK investors.

The Inflation Outlook

Policies used by governments to resolve the global credit crisis were both unprecedented and untested.

Therefore, the implications of such enormous stimulus are unknown and despite inflation having stayed relatively contained to date, the chance of a sharp rise in inflation is increasingly preoccupying the minds of investors. In the UK, the Bank of England’s programme represented more than 10% of GDP, with the Bank buying £200 billion of Gilts. In the US, the numbers were even larger as a proportion of GDP and the US Federal Reserve Chairman Ben Bernanke spoke of “being very aggressive because we are trying to avoid deflation”.

Median Economist Inflation Forcasts

  

Source: Bloomberg (as at 31/12/2009).
 
So where is inflation heading? Most forecasters expect inflation to stay relatively contained in the near term (see median economist inflation forecasts chart below). Indeed, inflation models for the major economies built by our Quantitative Research team also tend to agree with these expectations. These models decompose each country's price index into its basket components, and then forecast trends of the sub-components, taking into account seasonality and one-off price changes like tax hikes. In the short term, we see subdued inflation in core consumer prices for the next 1-2 years in the US, Japan and the Eurozone due to high unemployment and corresponding downward pressures on salaries, service prices and rents. However, CPI inflation will be elevated in early 2010 because of rising energy prices in 2009. In the UK, we see comparatively higher inflation, caused by the depreciating currency, the effects of a VAT hike as well as potential for further VAT hikes post election.

The medium to longer term is where most uncertainty lies however. The commitment and speed of central banks to withdraw QE and reduce liquidity support, the extent of “redundant capacity” in developed economies and the external effects of China and rising commodities could all lead to sharply higher inflation. Therefore irrespective of the outlook for inflation currently, the extent of upside risks as well as an inability to adequately quantify the risk suggests that investors should ensure their portfolios are well insulated against the potential for inflation to rise sharply.

Inflation Hedge Solutions

So what are the investment options? In fixed income markets where inflation is typically the key enemy, inflation linked bonds are the natural solution. With coupons and principal indexed to a level of consumer prices and being typically issued by stable, high-quality countries, inflation-linked bonds have a demonstrated track record of being an effective, low-volatility hedge against inflation while demonstrating negative correlation to risky assets.

Outside of fixed income, there are many other investments that can insulate against inflation risks, although they all tend to have a higher degree of speculative risk. Real estate, for instance, is often cited as a good alternative hedge. However, it is usually less liquid and more volatile. In the same vein, gold has been closely correlated with inflation over the long term, although the speculation risk in gold investing does not make it a risk-free solution. Equities can also work as a good inflation hedge as companies with rising prices see their revenues increase. Indeed, equities have returned higher real yields over the very long term. However, their use as an inflation hedge is imprecise over shorter time periods, requiring excellent stock-picking skills. They also exhibit high volatility. Stocks in the natural resources, tobacco, food and pharmaceutical sectors are popular among investors for this purpose.

Looking Beyond Inflation-Linked Gilts

To enjoy the best results, investors should use a blend of solutions to insulate a portfolio against the inflation unknowns. However, little is often made of the fixed income portion as investors typically have a bias for inflation linked bonds in their home market, such as Index-Linked Gilts for UK investors. Instead, investors may be better looking globally in getting the best value of money hedge against inflation.

A global approach to investing in inflation-linked bonds offers three key advantages over domestic bonds. The first is the wider opportunity set and by looking beyond domestic markets, investors can better exploit valuation distortions and hedge against global inflation risks using a mix of the cheapest possible markets. For example, markets outside of the UK and Europe are currently offering attractive opportunities. The Japanese five-year inflation breakeven is currently -0.8%, which effectively means markets are pricing deflation of 0.8% a year for the next five years. In the US, 5 year inflation breakevens are 1.9% even though inflation in that economy is currently 2.7%. In the UK however, the market is typically expensive due to the “home bias” from local pension fund demand, and the market’s 10 year inflation expectation of 2.9% is high relative to the Bank of England’s 2% inflation target. Therefore, US and Japan inflation-linked bonds can offer a much cheaper source of inflation protection for UK investors after currency hedging.

Inflation Breakeven Rates

 
Source: Bloomberg (as at 29/01/2010) Eurozone breakeven rates are derived from Germany and France index linked government bonds.

Performance of Global v UK Inflation Linked Bonds



 Source: Bloomberg, Merrill Lynch Bond indices (to 31/01/2010).

The second advantage of a global approach is that it delivers diversification benefits. Global inflation linked bonds have demonstrated low correlation to other asset classes, being typically negatively correlated to equities and loosely correlated with regular government bonds. By choosing a global over domestic approach, the diversification benefit is improved.

The final reason is that the global inflation-linked market is a bigger and more liquid market. As the inflation linked bond asset class continues to grow, liquidity remains challenging in individual markets. A global approach therefore allows investors to better overcome illiquidity concerns and also gives active managers more alpha opportunities to exploit.

So what are the risks? The key risk of a global approach is whether a global hedge is a tight enough hedge against domestic inflation. However, inflation has typically demonstrated high correlation across regions, including during inflation peaks, and we believe the current unknowns reflect a greater risk of inflation rising globally. In the long-run global inflationlinked bonds have also typically exhibited high correlation with domestic inflation linked bonds, so the investment performance has never been too far apart. Finally, as global financial markets and economies become increasingly sophisticated and intertwined, the mobility of capital means that over time, real yields, inflation breakevens and inflation should become more closely aligned.

Inflation Across Regions



Source: Datastream (to 31/12/2009).



Source: Bloomberg, data from 31/01/79 to 31/12/09. *France CPI is used as a proxy for long history Europe inflation. RPI release is used for UK inflation history. Global CPI is approximated using weighted average of regional CPI’s.
 

FF Global Inflation-Linked Fund

Managed by Andy Weir, the FF Global Inflation-Linked Fund aims to generate an attractive real level of income by investing predominantly in inflation linked government bonds. The fund aims to outperform a currency hedged index of global inflation-linked government bonds by applying a multi-strategy approach to fixed income investing. This means that the fund, in trying to outperform its benchmark, adopts a range of strategies from within and amongst others, the global inflation-linked, interest rate and credit market universes. Relative to its benchmark, the Fund is currently overweight US and Japan inflation linked bonds while being underweight UK and Euro markets. We believe the UK inflation rebound is already priced in, inflation is expected to bounce back up at a faster pace in the US, driven by the lagged effects of an unprecedented monetary stimulus.


FF Global Inflation-Linked Fund - Performance


Source: FIL Limited, 31.12.2009. Performance figures are calculated net of fees in sterling terms. Benchmark is BofA Merrill Lynch Global Inflation Linked Government Index. Return since inception is annualised. Since inception date is 29/05/2008. Past performance is not a reliable indicator of future results. Returns may increase or decrease as a result of currency fluctuations.