Inflated confidence

Inflated confidence

One of the UK’s longer serving fund managers – with a better-than-average history of avoiding the bear traps that damage glittering reputations – admitted the other day to following a simple guideline.

She is a regular attendee of investment conferences where the great and the good give their views on the opportunities, threats and challenges for the year ahead.

She listens dutifully to the speakers and then scours the agenda for what is never mentioned – and that is what she worries about. It is not the things you don’t know which cause you problems, as they say, it is the things that you think you know that turn out not to be true.

This is why she is currently worrying about inflation. For 20 years now it has not been a serious issue; indeed it has been the fear of deflation, its polar opposite, which has been a major concern. Recently, however, things have begun to change, particularly in the UK.

Sterling suffered a sharp devaluation last summer following the referendum vote to leave the European Union. The higher import prices that inevitably resulted are now feeding through in rising shop prices and squeezing consumer spending.

Thus far however the Bank of England’s Monetary Policy Committee (MPC) is treating the current uptick in inflation as a one-off adjustment, a contained process which will work itself out without requiring a rise in interest rates.

The MPC may be right but there are reasons to be concerned that other pressures could feed in to make inflation more persistent. The devaluation has also hit margins at legions of small businesses which buy raw materials or services from abroad.

Most think they have no alternative but to pass these on – all the more so because foreign suppliers have simultaneously become less competitive. They are likely to soon be squeezed further by labour shortages.

Numbers of EU migrants are already falling before the imposition of any formal controls that may one day be imposed. This is partly because Eastern Europeans, in particular, now feel less welcome, partly because the devalued pound means they have a materially reduced amount of cash to send home.

Many are choosing Germany, Switzerland and Scandinavia instead, and the more this happens the greater the skills shortage in the UK, and the more employers will be tempted to pay more to poach workers from domestic rivals.

It is also an open secret that whichever political party takes power after the election, taxes are likely to rise.

This would lead to a further squeeze on disposable income and a further upwards pressure of wage demands. None of this is certain, but it is something that needs to be thought about more than it is currently.

At a recent marketing dinner hosted by a leading retail fund house the manager of its flagship bond fund managed a 20 minute presentation without mentioning inflation once. When challenged he said it was of no concern because even if it did surge it could be hedged. Indeed, it might bring further opportunities.

Well, up to a point. Inflation hedging is easy when it is low, but becomes a lot more costly if rates start to spiral – nudging 5% is something which the current generation of fund managers consider inconceivable. Nor is that the end of the story.

Inflation is toxic for fixed interest securities and any sign of it becoming entrenched is likely to provoke an adverse reaction among the millions of investors who currently believe bond funds are a safe haven.

We might be surprised by how few of them need to head for the exit at the same time to cause pressure on liquidity, and at least some embarrassment for fund managers.  

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