Is your portfolio prepared for rising prices?
2011 has started badly for us Brits thanks to the VAT hike, accelerating fuel costs and runaway rail fares. Oh, and rising food prices.
Inflation is back, even if the Bank of England is pretending it isn't.
Is it here to stay, and if so, what does that mean for your portfolio?
The Great Inflation
You could call inflation the elephant in the room, except more people are now talking about it. The latest is Tom Becket, chief investment officer at Psigma Investment Management (pdf file). We may be moaning about price rises in the UK, he says, but we have it easy compared to consumers in the industrialising world.
The real inflation rate in countries such as China is close to 10%, driven in particular by soaring food prices. With the oil price motoring towards a headline-grabbing $100 a barrel, and copper and other metals at record levels, it is hardly surprising that consumer products are getting more expensive.
Latest data from the UK shows input prices are increasing at the fastest pace recorded. Becket warns of "clear and present danger for the global economy", and makes a decent stab at coining a name for what is coming our way: the "Great Inflation".
I wonder whether it will stick.
Don't worry, 'bout a thing
If you think we hate inflation in the UK, we have nothing on China.
Rising food prices usually leads to rioting in the countryside, and panic in Beijing. Central government will cheerfully sacrifice its double-digit GDP growth in a bid to keep costs under control, spreading panic in Western stock markets, which are cravenly dependent on the East.
Becket predicts "periodic bouts of China-inspired nerves" in stock and commodity markets on the year ahead, but mars his credibility by attributing his concluding words Don't Worry, Be Happy to "the great Bob Marley", when you, me and Wikipedia know it was one-hit wonder Bobby McFerrin.
Let's hope he is wrong about inflation, too.
You say CPI, I say RPI
The chances of inflation are growing rapidly as central bankers play fast and loose with the money supply. Cheap money is flooding the world, thanks to rock bottom interest rates and QE2, creating asset bubbles wherever it goes.
This has bailed out those greedy, unreformed bankers, and some hard-pressed homeowners, but we could pay a heavy price for taking inflationary prospects too lightly.
In early 2010, the Bank of England claimed CPI inflation would end the year at 1.5%. Wrong. It ended the year at 3.3%, while the benchmark we really should be using, RPI, stood at 4.7%.
The Bank once again refused to raise base rates this week, even as analysts warn it could soon top 4%, but that first hike is surely moving closer.
Agflation or stagflation?
Fund manager GAM thinks it has spotted an inflationary trend, and is planning to launch an inflation-focused fund to cash in on price rises. Its key themes will include agriculture, as rising living standards put pressure on limited arable land, and fuel inflation, where it plans to invest in companies supplying oil field services and equipment.
It believes metals, mining and transportation will all benefit from inflation, and will target these sectors. The new fund will also focus on companies that have real pricing power.
Hot commodity
Private investors are also pouring into commodities. Sales of commodity funds hit the highest level on record in November, when retail investors invested £208 million in the sector, according to the Investment Management Association.
My worry is that commodities are heavily cyclical, and tend to overshoot both on the upside and downside. Last year, they had a stormer, and I largely missed it. I'm wary about diving into these choppy waters now, because I don't want to end up riding the down wave.
That said, the long-term story for commodities should be good, as rapid growth in the developing world boosts demand for energy, food, and metals. But I prefer to buy on a dip, not a surge.
The Great Conflagration
You don't need me to tell you that high inflation will be bad for bonds. There might be some better news for cash, if the Bank of England concedes defeat and is forced to push up base rates, but securing a real, inflation-busting return will remain next to impossible.
Rising interest rates could also spell bad news for property, consumer spending, the retail sector and British exporters, if it forces up the value of the pound.
Stock markets may be a better place to sit out the Great Inflation then many of the alternatives, but that could change if the oil price surges past $100, without OPEC taking the necessary action to bring it down. This could single-handedly bring the post-credit crunch recovery to a juddering halt, leading to a sharp reversal in our appetite for risk.
By toying with inflation, central bankers are playing with fire. Make sure you don't get burned.
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