The markets have been undecided about whether we are going to encounter a deflationary spiral or an inflationary bubble. We’ve been clear on our view of inflation.
We expect deflationary pressure in the short term but that inflation will trump it in the long term. It’s easy to talk up the dangers of deflation because that’s what’s happening right now. Consumer Price inflation has fallen to 1.1% in September, down from 1.6% in August. So with prices trending lower, the safe play is to go with the flow.
What this doesn’t consider is that inflation expectations are actually higher in the UK than most other markets in the world. Using what are known as ‘break even rates’ we can see that longer-term expectations of inflation are in fact the highest for Britain. Here are the latest breakeven rates for the major economies:
Eurozone: 1.6%
Japan: -1.2%.
UK: 2.6%
US: 1.7%
This shows index-linked (inflation protected) bonds are pricing in a level of inflation significantly higher level than the rest of the developed world. Index linked bonds pay an extra amount of yield to normal bonds. The disparity between one region and the next is equal to the difference in inflation expectations. As you can see from the figures above, the markets are being very clear right now. The UK faces the greatest inflation threat.
Why do the markets see Britain as the most inflationary major economy?
Also, how do we play this trend now that bonds are already pricing in inflation?
Read on…
How the Bank of England could be engineering inflation
Relative to the size of the economy the UK central bank has been the most committed to quantitative easing.
Specifically, equity prices have remained firm since the influence of quantitative easing (QE). The purchase of gilts by the Bank of England serves to depress gilt yields, thereby driving investors into higher yielding corporate bonds and also equities. In time, QE flooding into the economic system will provoke a more general asset price inflation. How can investors protect themselves from this threat?
QE serves to depress long-term interest rates and at the same time stoking up inflation concerns in the long term. Both influences will serve to undermine the pound sterling (GBP). Furthermore the UK authorities are quietly happy with this state of affairs. A lower pound will help rebalance the UK economy towards exports at a time when financial services industry is not source of output, employment and tax revenue it once was.
A weaker pound will favour companies with large overseas earnings, while investors will benefit from those shares, which pay dividends in dollars. This development will favour larger UK companies. In fact 70% of profits from FTSE 100 companies come from abroad. So you could say that FTSE is more an international based equity index than a UK one. Certainly economic developments in the US and China have are more influential for our equity market than some would imagine. Shares like BP (LON: BP), GlaxoSmithKline (LON: GSK) and British American Tobacco (LON: BATS) derive the lion’s share of their earnings from overseas while BP pays a dollar dividend.
Why it’s time for defensives
So a portfolio of equities consisting of high yield, defensive overseas earners is well placed to deal with a less exciting economic recovery than is currently baked into the value of some growth stocks. Moreover, this portfolio offers protection if weakness in the pound turns into a rout.
Back in March, cyclical equities rallied to extraordinary levels. At the time we did not quibble with the analysis and indeed found some elements persuasive, but our contrarian instinct prevented us from following the crowd. We opted for safer but equally profitable markets, finding success by investing in investment grade corporate bonds.
The problem of the overextended consumer, precarious bank balance sheets, rising unemployment and ballooning public debt has not gone away. With such headwinds facing the recovery, it is very unlikely that growth stocks will continue to outperform defensives as they have done recently.
Accordingly we have a bias towards defensives and see no reason to re-position it in favour of growth stocks which look overextended. A handful of select defensives will do well in this climate.
Kind regards,
Brian Durrant
For The Right Side
Editor’s note: Brian Durrant is chief economist at The Fleet Street Letter, the UK’s longest-running investment newsletter. The team’s inflation protection report is essential reading. Don’t miss out on it. Read here to see how you can protect yourself and even profit.
Please note: Your capital is at risk when you invest in shares; never risk more than you can afford to lose. Please seek independent financial advice if necessary.
