Should investors be worried about rising inflation?

James Foster considers the impact of the coronavirus and explains why he is sticking to shorter-dated government bonds.

Inflation in the UK rose by 1.8% year-on-year in January, the fastest rate of growth for six months. Should we be worried about the longer-term trend? Our answer is yes; and for two main reasons.

First, demographics. The UK’s population is ageing. Many would present this as a reason to be sanguine, because an older population will slow growth. They would cite Japan as the example of where an ageing population has been associated with deflation. We would disagree. We believe that supply and demand will be the driving factor in the future. As the supply of labour will be lower, the price of it will rise. We are already starting to see this. The minimum wage is set to increase and wages in general are rising. The new “points-based” immigration system will also constrain the supply of workers. Automation will take over some jobs, but robots cannot (yet) be carers or pick strawberries, for example. For a primarily service-based economy, this will be inflationary.

Second, over recent years globalisation has been a very powerful force in pushing prices lower. As populism rises around the world, globalisation will reverse. The UK pulling out of the EU is one example. The US undertaking trade sanctions with China is another. Tariffs increase prices and therefore inflation. At the moment, the chances of the UK agreeing a trade deal with Europe seem remote. Our former partners in Europe are all airing their grievances. For Greece, it’s the Elgin marbles. For Spain, it’s Gibraltar, and for France it’s everything else – but especially fish!

To be fair, now is the time for countries to put in their demands, as a deal will only ever be concluded at five minutes ahead of the deadline. But don’t be surprised if the conclusion is no deal. And that would be inflationary.

Will the coronavirus change things?The initial impact has been to destroy supply chains as Chinese factories close.Less supply implies shortages and prices going up.Clearly the demand for airline tickets will reduce and prices fall, but most people won’t eat less because of the virus, although perhaps they will eat out less.On balance, I suspect the virus will change some prices substantially, but over time won’t have much of an impact on inflation’s generally upward path.

To conclude, labour has been the poor relation compared with capital. Labour is fighting back and pay will increase. Some of that increase will be passed on to the consumer and so inflation will rise.

So what does this mean for gilts? This backdrop implies that the gilt market – which across its entire range of maturities yields less than inflation – is very poor value. In addition, the UK government has just signed up to some very expensive capital commitments. For example, HS2 is 5% of GDP – admittedly over many (many) years. The government’s spending taps are on and this increases the supply of gilts.

Many of these trends are long term and will take some time to come through in higher inflation. But gilt markets are currently pricing in low inflationary expectations forever. So how should investors react?

We are especially cautious on longer-dated gilts, which are the most at risk from inflation and so potentially where most money could be lost. Coronavirus has only pushed bond prices higher as a safe haven and central banks threaten to reduce rates.A golden opportunity to exploit and sell your longer-dated bonds now.

Meanwhile, investing in inflation-linked gilts will not help much as the correlation between them and conventional gilts is very high. We are very wary and are sticking to shorter-dated government bonds.

James Foster manages the Artemis Strategic Bond Fund.