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Is it time to inflation-protect your portfolio?

Inflation rates are at record lows but with central banks poised to raise rates should you hedge against inflation while protection is cheap? Or is this time different?
September 16, 2015

You'd be hard-pressed to open the financial pages without coming across talk of US and UK interest rate hikes at the moment. Normally a rate hike signals a rise in inflation is on the horizon, which could have a major impact on your portfolio and which you should take steps to guard against. But not this time, say experts.

In other circumstances, now might have been a prime time to take out inflation protection. It is never good to be buying something at the point when you really need it. Inflation is low right now but the US Federal Reserve looks likely to raise rates at the end of the year (and, if history is anything to go by, the Bank of England would follow it) and central banks in Europe, Japan and the US have been injecting volumes of liquidity into markets in the form of quantitative easing (QE), which would normally stimulate inflation. But in the US inflation remains a long way off the Fed's 2 per cent target and in the UK it remains low.

The UK's inflation rate turned positive in July, with the Consumer Prices Index measure rising to 0.1 per cent from June's 0 per cent. However, UK consumer prices were flat in the year to August. The Bank of England expects inflation to remain around zero well into the autumn before climbing slowly.

That means it might not be the time to shop around for protection just yet. Normally central banks lift interest rates to keep inflation under control and will move to tighten policy to head it off. But strange things have been happening in markets in the past year. Those factors include the oil price slump and China's recent market crash, which have kept inflation low.

Darius McDermott, managing director at Chelsea Financial Services, says: "Most of the managers I've been speaking to are more concerned about deflation than inflation. The fall in the oil price from $100 to $40 is a deflationary effect and also food hasn't been going up because of price wars in the supermarkets and greater competition from discount supermarkets.

"My view is that inflation will stay low or moderately low for another 12-18 months. Historically QE is an inflationary tool but here we are 6-7 years in and nothing."

John Pattullo, co-head of retail fixed-income at Henderson, also believes low inflation will continue, blaming not just oil but Uber and Airbnb too, and predicts lower-for-longer rates. He says: "We would highlight the extraordinary effects that technology is having on increased utilisation of existing capacity, particularly through the shared economy. This is bringing prices down in many industries, contributing to the deflationary forces gripping the world."

So now is not the time to be panicking. But it could be a good time to get inflation protection at a bargain.

Paul Jackson, head of research at exchange-traded funds provider Source ETF, says: "You want to be buying inflation protection while it's cheap. I do think it's too early if you are thinking about buying short-dated bond funds. But if you're looking at five- to 10-year bonds and playing with that part of the yield curve then yes, it could be a good time to be buying inflation protection."

Mr McDermott says: "Historically this might be the time to take out protection but the Fed is considering raising rates because the economy is doing well, not because inflation is up, so unusual things are happening. However, what you should be able to do is get some inflation protection at a reasonable price.

"The one fund which does exactly that is M&G UK Inflation Linked Corporate Bond Fund (GB00B460GC50). Manager Ben Lord buys inflation-linked bonds or creates them using derivatives, so that would seem a sensible fund to be bringing in to a portfolio if you had inflation fears, even if it's only a small weighting." M&G UK Inflation Linked Corporate Bond fund is a member of the IC Top 100 Funds.

Typically, inflation-linked bonds are the way to protect against inflation. However, experts say that short-duration bonds, whose value is not depleted by rising interest rates, would be enough protection currently. Jason Hollands, managing director at Tilney Bestinvest says: "If you were taking a trading view you might be looking at inflation-linked bonds. But for most investors short-duration bonds would be the place to be right now but not inflation-linked ones."

A way to avoid making those decisions yourself is to be in a strategic bond fund, which offers the manager the ability to move between different types of bonds. The IC Top 100 Funds include Henderson Strategic Bond (GB00B03TP539) and Jupiter Strategic Bond (GB00B4T6SD53), which currently has 27 per cent of its portfolio in three- to five-year duration bonds. Hargreaves Lansdown lists Artemis Strategic Bond (GB00BJT0KV40) in its list of top funds. It has 23 per cent in five- to seven-year maturity bonds and 18 per cent in three- to five-year duration.

However, Mr Hollands says the best way to protect yourself might lie in equities and not bonds. He says: "We are not trying to take a view on the next quarter's figures and this is much more about the long term goal of beating inflation so ultimately being in higher risk assets like equities is probably the optimal way to stay ahead of inflation on long term."