Just how big is the risk of an inflation spike? Big enough that investors should consider what protection they have in their portfolios, writes Legal & General Investments' Dan Attwood.
It is fascinating how events that initially seem extreme can quickly become commonplace. We have seen this in effect with quantitative easing (QE): what began as an emergency measure soon evolved into routine policy, so it came as a shock to the market when Ben Bernanke announced the Federal Reserve was considering ‘tapering’ its asset purchase programme.
Concerns over the inflationary impact of QE are perfectly understandable, although, so far, inflation has remained relatively low in most developed economies, despite an improving economic backdrop. So, what is going on? Well, so far, the inflationary push of QE has been overpowered by the deflationary pull of economic recession and deleveraging.
It is hard to say how much longer this will persist. It is looking fairly unlikely that inflation will spike in the near term. Over the long term, however, there is a very real risk of higher inflation and, as the recovery in developed markets such as the US gathers strength, this risk will increase.
Why portfolios light on inflation protection are vulnerable
Tightening monetary policy in response to higher inflation is likely to be a hugely difficult balancing act for policymakers, especially given the Fed’s commitment to keeping interest rates low into 2015.
The Fed is likely to set the bar for other central banks, so if the US is too slow to exit its QE process and looks to tighten monetary policy, we could have a more broad-based global inflation issue later this decade.
Although we are certainly not one of the doom-mongers predicting inflation akin to the Weimar Republic, those with portfolios currently light on inflation protection might want to consider now a good time to get some.
Inflation-linked government bonds are one of the purest ways to incorporate inflation protection into a portfolio but, rather than focusing purely on gilts, it could pay to take a global approach.
The global market for this type of security is huge and gilts are just a part of it. Having wider horizons is likely to bring more opportunities and additional diversification benefits.
Looking beyond the UK brings another key benefit. The UK government has increasingly been issuing longer dated index-linked gilts and, therefore, increasing average maturity; however, outside of the UK, inflation-linked bonds tend to have a significantly shorter maturity profile, leaving investors less exposed to rises in real yields.
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