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Conflation conundrum

Interest rates have gone even lower this month as the authorities work hard to dig the UK economy out of its problems. The rapidity of economic changes and forecasts for potential incomes in recent weeks has added to the myriad of different issues and scenarios intermediaries need to assess when trying to advise clients in an already difficult environment.

Just six months ago, inflation was a concern for the Bank of England with interest rates less than a year ago on an upward trajectory. The quick reversal to interest rates at historic lows, and predictions they will be low for years to come has since created the debate of inflation versus deflation – which is more likely? Which is the greater evil? And how can an adviser prepare clients for an outcome that even the economists cannot agree upon?

Weeks ago, the debate may have favoured the deflation side of the argument but these days inflation seems to be garnering more attention from economists and fund managers.

Sitting more in the inflation camp is Fidelity enhanced income manager Michael Clark, who is basing his stance on the devaluation of sterling, an economy heavily dependent on imports combined with the massive stimulus programmes under way. Clark noted that in the past such a combination has inevitably led to inflationary pressures as companies look to move prices up to offset the falls in currency. Car dealers have already started to increase prices and Clark foresees that come mid- summer, so too will many of the retailers. He admitted in the current difficult climate that retailers are likely to take some of the sterling impact in stock on their margins but retailers will still want to share some of the pain and will increase prices. There is also the notion that consumers do have more disposable income than is thought. Consumers were squeezed from 2003 through to 2008 by higher energy, fuel and food costs and that has since eased while at the same time Government tax cuts, such as the reduction in VAT, have been implemented. “For 2009, those still employed will have a higher disposable income, particularly if they also have tracker mortgages as they will feel the impact more of the interest rate cuts,” he said, adding: “Retailers know this. This is a positive for consumer spending and is a significant ray of light for the UK economy.”

Food and gas supply will also be tight in the coming months, Clark believes, bolstering his argument that the UK is more likely to see a return to inflation than enter a deflationary environment.

New Star economist Simon Ward is also more wary of an inflationary environment at the moment especially as recent CPI and RPI figures both showed a less than expected decline.

“Contrary to the consensus interpretation, recent inflation news has been distinctly poor, with the cut in VAT and lower fuel prices masking a deteriorating underlying trend due to surging non-energy import costs. “The superficial view is that prices are slowing fast, with annual headline consumer price inflation down to 3 per cent in January from a peak of 5.2 per cent last September. However, using the CPI at constant tax rates, which adjusts for the reduction in VAT, the decline has been much smaller, from 5 per cent to 4.1 per cent. Moreover, this fall is fully explained by a drop in energy price inflation.”

According to Ward, without the Government’s VAT cut the CPI between September and January would have actually risen. “The recession will restrain domestically-generated inflation but higher import costs may continue to have an offsetting impact, barring a significant exchange rate rally,” he said. Ward predicts inflation will rebound in early 2010.

Politicians appear to be among those believing in the deflation scenario, as evidenced by Liberal Democrat Shadow Chancellor, Vince Cable. He said: “One of the few reassuring facts for hard-pressed families is that inflation is now virtually disappearing. It is becoming clear that for the foreseeable future there is a higher risk of deflation than inflation, which is why it is inevitable and sensible that the Bank of England should be moving towards expansion of credit and the money supply directly.”

Investec strategist Max King also believes there is now a greater chance for inflation over deflation, with expectations for the latter already fading fast. That said, King does not believe the UK will end up in a high inflationary environment as the continuation of globalisation will keep it relatively low. “Deflation will not happen – fear of it is being used by the authorities as an excuse for gross extravagance and monetary madness,” he said.

The authorities can always counter deflation by doing what they like best – spending, cutting interest rates and printing money, King added. “The painful remedies for inflation – higher interest rates, cutting spending, raising taxes, limiting credit – are much less pleasant. We think that the authorities will therefore always fight deflation but take risks with inflation,” he added.

Amid the uncertainty of the economic outcome and state of the UK economy, advisers have to try to work out the viability of the various scenarios in order to determine the best place for client assets.

A deflationary environment will favour bond investments but a return to an inflationary situation will favour the currently downtrodden resource sectors. Commodity and resource funds were popular sales last year but after the dramatic falls in oil and commodity prices in the autumn, they are currently the worst-performing fund areas in the UK funds’ universe.

King commented that deflation is a positive for government bonds while equities would struggle, although some stocks with pricing power could benefit. Meanwhile, as the 1970s showed, inflation is a disaster for bondhol-ders and can also hold back equities.

Rob Burnett, head of European equities at Neptune, said the excess supply still seen in the OECD economies is deflationary but it is being combined with the inflationary force of economies printing money to work out existing problems. “The two will meet at some point but what will happen? It is impossible to quantify,” he told delegates at a recent Fidelity FundsNetwork roadshow.

Today’s unusual situation could lead to some surprise outcomes, leading to government debt spiralling out of control and a squeeze on anyone with any debt at all. King suggested in this environment, investors will be likely to look to gold but should switch to equities when the end of inflation comes in sight.

Whatever the outcome of the UK economy, which seems increasingly difficult to predict, companies will eventually adapt to any environment: inflation or deflation if they have good management, King added.

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