News Archive

With the Government, the Opposition, the Bank of England, and the market all at odds over the inflationary picture down the road I hope that the following comments from City Financial Strategic Gilt fund manager, Ian Williams, are helpful for advisers and their clients. – Andrew Williams, Chief Executive, City Financial

Inflation or deflation – advisers are asking, how do I stay on the right side of this?

Over the last year investors and their advisers may feel a bit like they’ve been thrown into the proverbial deep end of the pool. A litany of negative headlines, heralding an economic landscape scarred by bank failures and surviving on unprecedented government support, has spurred high and often irrational market volatility.

As the pricing of assets has divided the market, similarly, forecasting what’s down the road – inflation or deflation – has split the experts. Many believe that the Government’s policies of excessive spending, lower taxes, rock bottom interest rates, and quantitative easing are absolutely essential to help the UK climb out of this economic hole. Still others believe that these policies amount to fiscal recklessness on a scale hitherto unknown and will spur dangerously high inflation.

This debate was once again the focus of attention of media pundits when on 23 March the Office of National Statistics confirmed that year-on-year CPI-based inflation rose to 3.2%, from 3.0% in January.

While the Bank of England may believe that the dangers of a deep and prolonged recession still outweigh the risks of inflation, this announcement of an unexpected jump in inflation is in stark contrast to their previous forecasts. It clearly calls into question the risks associated with quantitative easing.

To make matters worse, on 25 March the Government suffered the first failed gilt auction in almost seven years, reinforcing doubt that they will be able to fund their massive budget deficit through the sale of gilts.

Inflation is measured in a rather complicated two-fold manner. The Consumer Price Index (CPI) tracks a basket of over 650 goods and services meant to represent a realistic sample from which to gauge consumer spending patterns. The Retail Price Index (RPI) attempts to price the cost of living by adding to this basket of goods the costs of energy and mortgages, as well as housing prices. It’s this index – the RPI – that is used in calculating adjustments to rail fares, pension benefits, and crucially for a gilt fund manager, index-linked gilts.

The recent rather precipitous drop in RPI can mostly be ascribed to the dramatic series of interest rate cuts that have brought down the cost of tracker mortgages, as well as declining home and energy prices. The uptick in CPI is mostly the result of a rise in imported food prices. As Sterling has lost value the cost of importing food has increased. The much publicised jump in inflation refers to an increase in CPI, while RPI has fallen to nearly nil.

Complicating the situation further, over the last ten years RPI has tended to be higher and more volatile than CPI (see graph). Today, we find ourselves in a scenario where RPI is materially lower than CPI. How will this bode for the Government’s ability to hit its target of 2.0% CPI-based inflation? A flurry of questions come to mind...

Will signs of economic improvement cause interest rates to be raised?

Will Sterling remain weak?

Will future gilt auctions fail?

What effect will the expiration of the temporary VAT reduction have on consumer spending and retail pricing?

How will quantitative easing, and the swollen money supply, play out in a recovery? Or, in a deeper downturn?

The task of a fixed income fund manager is to sort through and answer such questions. What, however, is bothering advisers? Perhaps, in the midst of such contradictory forecasts advisers are simply wondering, how do I keep my clients on the right side of all this?

When it comes to gilt investing inflation can be a key determinant in the success or failure of an investment. As the purchasing power of each Pound decreases, the value of a bond, with its fixed coupon, also decreases.

There are, however, tools at the disposal of a gilt fund manager to help mitigate this fact. By allocating a portion of the City Financial Strategic Gilt Fund to index-linked Gilts we have decreased the level of inflation exposure in the portfolio. This partially safeguards the Fund from future unexpected spikes in inflation. Using this tool in conjunction with modifying the average duration of the underlying bonds, writing options, and taking cash positions, we actively manage the portfolio to adjust to the challenges presented by these unpredictable times.

The prognosis for the future is uncertain. The cleverest and most informed voices in the market are at odds with one another. As advisers continue to confront today’s challenges they should lean on the expertise and focused attention of a proven team of investment professionals to help them safeguard their clients’ long-term savings portfolios. In managing the City Financial Strategic Gilt fund we have the tools and skills to adapt to an ever-evolving market landscape and to best position the portfolio for future growth.

The City Financial Strategic Gilt fund remains a sector leader in 2009, after having returned in excess of 10% in 2008(1). Since launch in December of 2006, the Fund is number one in the IMA UK Gilt sector having returned over 20% during that time(2).

1. Source: Lipper, 31/12/07 – 31/03/09.
2. Source: Lipper, 08/12/06 – 31/03/09.