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As CPI falls will demand for inflation-proof funds sink?

As CPI falls will demand for inflation-proof funds sink?
Investors have been piling into inflation-proofed funds over the past two years, but the news that the Consumer Price Index (CPI) hit a 26-month low in January brought their value into question?

Although broadly in line with expectations, the fall from 4.2% in December to 3.6% is a far cry from the three-year high of 5.2% seen as recently as last September.

‘The key factor behind the 0.6% decline was the increase in the standard rate of VAT from 17.5% to 20% in January 2011 dropping out of the annual comparison,’ says John Clarke, economist at GHC Capital Markets. ‘As result, the drop in inflation was felt pretty much across the board, although the largest contributions came from transport, restaurants and hotels, and alcoholic beverages and tobacco, primarily because prices did not increase by anywhere near as much as in January 2011.’

Consensus suggests that inflation, while still well above the Bank of England’s (BoE) 2% target, will continue to decline and approach that figure by the year end.

Although this will mean a much lower hurdle rate for investors to beat in order to avoid any erosion of their wealth, it will remain significant in the current low return environment, argues Stephen Jones, manager of the Kames Capital Inflation Linked fund.

‘While it will come back towards the target, inflation is still high and investors need to be fully invested to counter it,’ he says. ‘There are two parts to it, the monthly inflation print and the fact that interest rates look set to stay at very low levels for a long time to come yet.

‘People’s worries will also persist and by definition a lot of inflation-fighting assets are very defensive, which is attractive in a “risk off” environment.’

Investor appetite for inflation-proofed investments has been strong, with the Kames Inflation Linked fund attracting £263 million since launch in July 2010. Those who bought into the fund have been well rewarded as it returned 20.54% in 2011, according to Lipper.

And while it may be a stretch for the fund to replicate that performance this year, Jones believes there is still value in inflation-linked government bonds, gold and blue chip defensive equity names.

‘We still think index-linked bonds at the core of a portfolio offer value,’ he says. ‘We believe that the yield curve will continue to flatten and longer-dated bonds will do well.

‘We are also a bit sceptical that everyone is happy to believe the BoE’s forecasts now, but there is an embedded assumption that there is a lot of spare capacity that can be switched on to offset any inflationary problems. We think that is a bit hopeful and inflationary pressures may be a bit more stubborn that expected.’

Stuart Thomson, co-manager of the £18.3 million Ignis Absolute Return Government Bond fund, is anticipating a decade of low growth with little in the way of inflationary pressures and without the threat of deflation.

Opportunities galore

Thomson believes this will still provide plenty of opportunities for investors, however.

‘We have sold inflation forwards and as long as the Retail Price Index (RPI) does not fall below zero, we will make a lot of money,’ he says.

‘We have also shorted base rate forwards due to structural quirks and have made money out of base rate floors. We don’t believe that the BoE will move rates below 0.5% because it saw the damage it did to the money markets when the Federal Reserve did it, it would rather do more quantitative easing (QE).’

He says that any pause in the BoE’s QE programme could leave the UK market vulnerable to a temporary uptick in higher long forward rates until it is restarted, which he expects to happen in May.

‘On the basis of what the BoE has said, it is 50/50 that we get more QE in May because growth won’t meet those forecasts,’ Thomson says.

‘While this crutch is removed, we feel the market is susceptible to a temporary blip in higher long forward rates until the programme is restarted. This will provide a very good opportunity to re-enter the position.’

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