One of my colleagues recently came across the following quote from Ronald Reagan: “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”
I assume the quote is from the 1980s but it highlights the impact inflation left on a generation. The current generation of investors, by contrast, has never experienced inflation that creates quotes such as that of the late president. Is that about to change?
I am convinced that inflation is returning but complacency has set in, with the traditional asset allocation split inadequate to meet the needs of the new scenario. For the sake of clarity, I do not believe we are returning to a 1980s environment; UK consumer prices index data ‘only’ goes back to 1989, but inflation then was 8.4 per cent.
How many of my industry colleagues have the collective memory going back that far (I have two), when rates were between 10-15 per cent?
It gets worse when one assesses the 1970s environment when the retail prices index (RPI) in 1975-79 hit 26.6 per cent with rates at 12 per cent. I am not suggesting we get back there, but I believe we have been lulled into a false sense of security. How many of us believe we could survive a rate environment with inflation far greater than we have become used to? Do we have the toolkit to navigate this environment?
Why do I believe inflation is on the march? From a low base, there is growing evidence of a return of the Phillips curve, highlighting the inverse relationship between the level of unemployment and the rate of inflation. A second indicator is commodity inflation, and changes to fiscal policy in the developed world will also have an inflationary impact.
Inflation rates of even mid-single digits will be hard to stomach, especially for lower risk clients invested in cautious mandates that are heavily skewed to government and corporate debt.
I do not believe the traditional toolkit is set up for an inflationary environment. In the last inflationary period, the playbook was relatively straightforward; inflation linkers, for obvious reasons, and, to a degree, equities – but that was in the day when many of the latter had pricing power.
There are more inflationary orientated ideas out there, but one has to search for them and they do tend to be specialist; funds such as Time Commercial Freehold and a number of the closed-ended infrastructure funds such as INPP, where returns are often RPI-linked.
It did not take me long to realise why so few managers use inflation as a benchmark versus the much easier option of Libor plus a small percentage, especially if there is a performance fee attached.
I would urge fund management groups to be brave and launch funds that target an inflation-plus return – where this return is derived is the manager’s skillset. In fact, asset managers would do well to take a leaf out of Ardevora’s book. Its UK Equity Fund has a share class that has a lower base fee with a performance fee if the manager achieves RPI plus 5 per cent.
James Calder is research director at City Asset Management
