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The manager of the City Financial Strategic Gilt Fund explains that the recently announced policy of quantitative easing amounts to little more than the modern day equivalent of printing money.

I hope that the following commentary by Strategic Gilt Fund manager Ian Williams is helpful for any investor facing decisions during the ISA season.

“No time for a novice”

The Bank of England has embarked on a new course into uncharted waters. With the adoption of a quantitative easing strategy, the Bank hopes to relieve the strained economy and to encourage lending institutions to get back to business. However, when all the jargon is stripped away it becomes clear that this strategy amounts to little more than the modern-day equivalent of printing money. This approach has serious longer-term inflationary implications.

Globally, governments are drafting stimulus packages aimed at limiting the length and depth of what the International Monetary Fund last week termed the Great Recession. Though these initiatives vary in degree of size and approach angle what they have in common is that the public is taking on massive amounts of private debt. The United Kingdom is no exception, and to fund its budget shortfall the Treasury’s Debt Management Office (DMO) must auction gilts.

Though, with a record £125Bn budget deficit, are there sufficient buyers? The short answer is no.

As a result, the Government must step in as the buyer of last resort. But by the terms of the European Union’s Maastricht Treaty, the Bank of England cannot buy gilts directly from the Treasury. There is, however, a loophole. If the Bank of England buys gilts on the open market, reducing gilt supply and fuelling demand, it is then easier for the DMO to sell new gilts in that same market.

In effect, the Government is using the Bank of England to fund its swelling budget deficit, and the gilt market as the middle-man in the exchange. By flooding the market with gilts, the Government, in its efforts to stimulate the economy, is artificially manufacturing inflation. This is so because in spending the money generated by gilt auctions across the real economy, from the construction of schools to funding the reduction in VAT, the Government is stoking demand.

Through these policies, the Government can continue to prop up the financial system and to absorb the distressed assets that make it difficult to price risk, and hopefully, in time, usher in the climate necessary for recovery. While they may serve to stem deflation in the short-term, by spurring inflation, they drastically increase the likelihood of inflation in the medium to long-term.

As prices rise and wages remain the same, consumers feel the pinch. Similarly, as the purchasing power of each pound decreases the value of a bond, with its fixed coupon, also decreases. This means that the values of bonds are especially susceptible to inflation.

PIMCO, which runs the world’s largest bond fund, wrote in a note last week that they believe as soon as 2010 the US government’s policies may reflate the American economy. If this occurs, a myriad of pressures, from an expanding money supply to resurgent demand for commodities could cause a sharp and painful spike in inflation. Having taken this view, PIMCO fund manager Bill Gross has been making ample use of the inflation protection offered by inflation-linked US government bonds.

Similarly, by allocating to index-linked UK gilts, a gilt fund manager is capable of decreasing the level of inflation exposure in the portfolio, as we have done in the City Financial Strategic Gilt Fund. This may seem very simple, however, the complicated bit is in knowing, when, of what duration, and how much to buy.

In other words, how to actively manage the portfolio.

There are times when a rising tide lifts all boats. And there are other times when a deft navigator is needed to negotiate sandy shoals. The threat of inflation is real; this is no time for passive investment management, no time for a novice.

Last year, the IMA Gilt Sector delivered an average 11.76% (Lipper: 31/12/07 – 31/12/08). It was very much a buy-and-hold year. This year remains largely uncharted and there will undoubtedly be opportunities of which to take advantage, but only through maintaining a balanced view and being vigilant.

Ultimately the market is choppy and actively managing a fund, keeping it flexible and steering it properly, is the only way through.