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Adviser Fund Index

Inflationary pressure in Britain is not necess-arily the threat that many were expecting coming into 2011.

Nevertheless, the Office for National Statistics confirmed last week that the Consumer Prices index, the measure the Bank of England uses for its inflation target, increased to 3.7 per cent in December. This is some 170 basis points above the Bank’s 2 per cent target.

The Bank says Government cuts should coun-ter the current trend and bring CPI back closer to target. With a number of economists now raising their inflation expectations for the year, however, the problem for asset managers is how to protect capital against a backdrop of low bond yields and rising inflation.

Chartwell Investment Management head of fund research and Adviser Fund Index panellist James Davies says: “It does seem a fairly firm inflation picture. There is nothing that has dissua-ded me from that view at this point.”

Davies says he increased his exposure to equities and cut fixed interest weightings as a result.

The trend appears to be a growing one. In the January Bank of America Merrill Lynch Fund Manager Survey, a net 55 per cent of global asset managers were overweight equities, the highest reading since July 2007. Conversely, a net 54 per cent of managers are underweight bonds, the lowest level since August 2007 and up from 47 per cent underweight last month.

At this juncture, high equity weighting may not reflect extreme optimism at the outlook for global markets but it is nevertheless evidence that investors are moving up the risk spectrum in order to access potential returns. For some, this indicates that the risks in the system may in fact be building up rather than dissipating.

Hargreaves Lansdown senior investment manager Ben Yearsley says: “Inflation is certainly not good for anything in the short term. It is interesting that equities are being bought now, some 18 months after markets bottomed.”

Of particular concern is the amount of money moving into emerging markets. Although there is plenty of grounds to make the case for the medium-term economic outperformance of many of these markets relative to developed economies, that does not necessarily suggest that their equity markets will not outpace underlying growth through huge foreign capital flows.

After a number of fund groups, including First State and Thames River, issued warnings of a potential bubble in these markets, investors may have to revisit the case for investing.

Davies says: “If the prompt for an emerging market crash is policy tightening or a reversal of economic performance, there is probably no place to hide. If, however, it is just a slow retreat of sentiment, then the turn might not be so sharp. We have slightly reduced our exposure to those markets.”

Despite the risks, it seems that investors are still looking at 2011 as a potentially lucrative year. Yearsley says: “Equities are not looking too expensive yet as earnings have kept pace with rising markets. Also, inflation is not going to impact the economy too seriously unless the monetary policy committee raises rates. The longer you have QE and low interest rates, the more money that is likely to flow into equity markets.”

Whether policymakers and investors alike will be able to avoid the pitfalls will largely depend on their ability to understand and anticipate one another. The past may be pockmarked by missteps in this regard but as every fund factsheet will tell you, past performance is not necessarily indicative of future results.

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