While the global investor community takes sides in the ongoing inflation-deflation debate, the UK is experiencing an interesting debate of its own where the choice is between sustainable and high inflation as economic growth remains the overriding policy priority. As a result, those with UK-centric portfolios should actively consider hedging UK inflation risk. At the same time, due to somewhat obscure recent changes to pension regulations, inflation-linked gilts (the most common form of inflation insurance) may get relatively cheaper in the near-term future.
Although officially undeclared, the Bank of England has actively pursued a weak sterling policy during the current economic crisis in a bid to bolster export performance and hopefully allow for a much wanted rebalancing of the UK’s economic growth pattern away from absolute dependence on domestic demand, and, within this, the financial sector. From a macro standpoint, attempting to bring about long-lasting structural changes simply via FX differentials always looked difficult to achieve. One can argue that any near-term benefit of a boost in export demand in a net importing economy such as the UK not only would be temporary in nature, but could be more than offset via imported price pressures.
If recent inflation data are to be taken at face value, it seems as though there is truth behind this assumption. UK inflation, as measured by the consumer price index (CPI), has been well above the BoE’s price stability target of 2.0% throughout 2010. Even accounting for statistical base effects from potentially one-time increases in year-on-year energy price components of CPI (due to the large increase in energy commodity prices through late 2009), inflation continues to surprise to the upside both on total and core measures. In fact, the benefits of these statistical base effects may well be nullified come winter, with energy companies already warning of necessary increases in gas and electricity prices. Measures of inflation expectations for the coming year have also been throwing in uncomfortably high readings.
The BoE MPC’s (Monetary Policy Committee) official line remains one of confidence that the level of spare capacity in the economy, expected to be enhanced via a substantial fiscal tightening drive, should bear down on inflation to bring it back to target within the policy horizon. However, the MPC is no longer a unified decision-making body. The first MPC member to break ranks and raise the inflation alarm has been Andrew Sentance, who voted to raise interest rates by 0.25% to 0.75% at the June 10th policy meeting and again on July 8th. While he remains a lone voice, it is one that is providing plenty of food for thought. In fact, on July 28th, addressing a parliamentary committee, the BoE Governor Mervyn King acknowledged that price pressures were indeed higher than the BoE had predicted. However, Mr King also made it clear that in the trade off between growth and inflation, the current priority remained growth. In other words, the BoE, or at least the majority in the rate-setting MPC, would not be in the business of choking the recovery by hiking interest rates. This view was further confirmed in the August Inflation Report, published on August 11th, which saw a downside revision to GDP growth forecasts alongside confirmation that inflation would indeed be above target for the whole of 2011.
UK interest rate 2001-to present:
Against this backdrop, UK inflation protection is thus seen as a necessary complement to core investment portfolios. The UK government inflation-linked bond market is one of the best developed in the European landscape, with the Debt Management Office (DMO), the UK’s government issuing agency, regularly tapping the market to enhance liquidity. Those wanting to get a degree of UK inflation protection via the ETF route could for example look at the iShares Barclays Capital Sterling Index-Linked ETF, a vehicle which aims to track the performance of the Barclays Capital UK government inflation-linked bond index. The fund’s composition reveals a significant bias towards long-dated maturities (e.g. over 15 years), reflective of the DMO’s own bias towards long-dated inflation-linked gilt issuance, in turn reflecting the nature of institutional demand for this type of product. The natural buyers of UK government inflation-linked bonds are pension funds, which use them to hedge against inflationary pressures on fairly long-term horizons.
At first sight it looks a straightforward proposition; one needs to get protection against UK inflationary pressures and an ETF like the one provided by iShares could do the job. Well, yes, but maybe not quite. The recent performance of the UK government inflation-linked market, and by extension any financial product tracking it, has had little to do with economic agents’ views on inflation and a lot with proposed changes to the way the UK government manages public sector employees pensions. In early July, the Department for Work and Pensions (DWP) confirmed that as part of the overall budget deficit-cutting strategy, public pensions would be now be annually upgraded by CPI rather than the traditionally-used Retail Price Index (RPI) measure, which includes mortgage costs and has overshot CPI by an average of 0.8% since 2000. More importantly, the DWP also announced that it would allow private pension funds to adopt the same indexation methodology. The problem is that all UK government inflation-linked bonds upgrade to RPI rather than CPI. Upon the DWP’s announcement the UK government linker market experienced an unwinding of long positions, with would-be buyers turning into tactical net sellers on expectations that RPI-based products could become obsolete for private pension provision. This overall market underperformance has been duly reflected in ETF space.
CPI vs. RPI 2000-to present (y/y rates):
It clearly is very early days and the initial market reaction could well prove a typical knee-jerk move to an unexpected policy decision. After all, any transition to CPI-based products would take considerable time and it is by no means guaranteed that the majority of private pension providers would switch. Morningstar has been in contact with the UK’s DMO and they have confirmed that while they are closely monitoring market moves and are ready to listen to feedback on possible actions to meet market requirements, they have no plans to introduce CPI-linked government bonds at this stage. Any such move would require a comprehensive period of consultation with the likes of private pension providers.
As of now, both investors and ETF providers have little choice but to continue tracking the RPI-linked gilt market. However, it will be wise to keep a very close eye on developments, as future UK government gilt linker market performance may not necessarily be largely dependant on fundamental views on inflation but rather the result of a policy-driven migration from RPI towards potential new CPI-based products. This can potentially exert upside pressure on real yields of RPI-based UK government inflation-linked bonds, thus impacting breakeven inflation rate calculations--a common market measure of inflation expectations--to distort the message given to investors. Indeed, to the naked eye, a falling breakeven inflation rate is tantamount to assuming the market expects diminishing price pressures in the future. However, we may be faced with a situation whereby falling breakeven rates might simply indicate shifts in UK institutional investors’ asset allocation and not a signal to short inflation hedging in one’s portfolio.
