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M&G's Lord: how we're going to deal with high inflation
by Robert St George on Oct 30, 2013 at 11:28
Ben Lord, manager of the £775 million M&G UK Inflation Linked Corporate Bond fund, has recognised that ‘inflation isn’t a problem at the moment’, predicting that UK inflation will continue to hover around the 3% mark in the months ahead.
But, for three reasons, Lord (pictured) argued at the Wealth Manager Retreat that inflation will become a greater concern in the years to come.
First, Lord contended that while an ageing population will depress economic output as more people retire, their consumption will not similarly fall, and so prices will climb.
Second, Lord observed that inflation has now been higher than the Bank of England’s 2% target since late 2009 – a period of deleveraging that should have been disinflationary – so should pick up even more as growth returns, as he believes it will. ‘We think the recovery has legs,’ Lord said, highlighting positive indicators from the services, construction and industrial sectors, from house prices, and from employment.
‘This has been one of the most benevolent recessions in employment terms,’ Lord claimed. He favoured employment as an economic gauge because it is easy to measure and hard to manipulate, and noted that in the 20 quarters since the 2008-09 recession employment has surpassed its pre-crisis level. At the same point after the 1980-81 and 1990-91 recessions it was still 5% down.
Third, Lord reckoned that the vast sums of newly created cash on the Bank of England’s balance sheet will soon flow into the economy, through schemes such as Funding for Lending. ‘It’s a pretty heroic assumption to say that the transmission system will never be fixed,’ he responded to those who doubt such initiatives.
‘We are building inflation risks for the future,’ Lord summarised. To deal with it, he has adopted a three-pronged approach: inflation protection from index-linked gilts, income from high-quality credit, and short durations.
For the inflation protection, Lord runs a 13% weighting to index-linked government bonds based on their attractive valuations. The difference between five-year nominal and index-linked yields is just 2.8%; ‘My hunch is that inflation is going to be higher than that over the next five years,’ Lord stated. ‘Inflation protection looks cheap.’
However, Lord appreciated that index-linked bonds alone are insufficient. ‘We couldn’t launch a fund if it was just exposed to that small universe,’ he acknowledged: it would be almost entirely dependent on utilities and 20 or 30-year bonds, very illiquid, and not scalable to fund flows.
Lord has therefore used credit default swaps – ‘The liquidity benefit is enormous’ – for exposure to corporate credit. At the moment, he has been switching from the US to Europe amid fears that American corporations are ‘aggressively’ issuing debt to finance returns to shareholders rather than growth.
The average duration in his fund is also now 2.5 years, compared with eight years for the iBoxx Sterling Corporate Bond index and 10 years for the Bank of America Merrill Lynch UK Gilt index. According to M&G’s calculations, a 1% spike in yields will result in a 2.5% capital loss for the portfolio against 8% and 10% for the two indices.
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