Private banks put brakes on inflation

Inflation used to be the frightful monster which haunted central bankers – the bogeyman star of scary bedtime stories they told their children, after a hard day at the office monitoring wage growth, commodity prices and other disturbing phenomena which might rouse the inflationary beast from its fitful slumber.

During the 1970s it wrecked both economies and stockmarkets, pushing corporate costs out of control, slashing purchasing power and fostering social unrest.

The happy ending came in the 1980s, when central bankers, led by Paul Volcker at the US Federal Reserve, acted to reduce inflation at all costs – including that of heavy recession.

That is now changing, and it appears the inflationary beast may once again appear, to complicate the allocation of private client portfolios. Current Fed chairman Ben Bernanke showed how far the US has moved by declaring in December that the bank would continue suppressing interest rates until unemployment had fallen to 6.5 per cent – an innovation which confirmed he is thinking at least as much about economic growth as inflation.

Two days before this Mark Carney, who becomes the Bank of England’s governor in July, had gone further still. He floated the idea of scrapping the Bank’s 2 per cent inflation target altogether, replacing it with a more growth-focused target for nominal gross domestic product (GDP).

Even the European Central Bank (ECB) is showing signs of taking a more relaxed attitude to inflation. It has joined the Fed and Bank of England with a form, in all but name, of quantitative easing aimed at stabilising the eurozone economy and provoking the ire of inflation hawks at the Bundesbank.

“All the central bankers these days want to reflate,” says Didier Duret, chief investment officer for ABN Amro Private Banking. “Clients are very worried about inflation because the central banks are printing money.”

Highlighting the tension created by their transformation from anti-inflation fundamentalists to self-appointed saviours of economic growth, Mr Duret adds: “You could say the central bankers are Keynesians and our clients are monetarists.”

Central bankers in Western economies are, say wealth managers, haunted more by the stubborn stain of deflation in Japan – which contributed to two decades of economic stasis – than the memory of the 1970s. “Central bankers in mature economies are still in deflation-fighting mode,” says Christian Gattiker, chief strategist and head of research at Bank Julius Baer in Zurich.

For their part, Japanese policymakers are making clear that inflation is not merely acceptable or even convenient, but a key aim. In March the dovish Haruhiko Kuroda was confirmed as the next governor  of the Bank of Japan, having been nominated by Shinzo Abe, the prime minister, who prompted a stockmarket boom by winning a landslide election victory in December on promises to end an era of falling prices.

“When a country’s leadership says it will use every possible policy tool to reverse 20 years of deflation, you don’t want, as an investor, to go against that,” says Yu-Ming Wang, international chief investment officer for Japan’s Nikko Asset Management. He believes that as a result of the US and Japanese policy pronouncements, “higher inflation expectations are in the early stages of taking hold” in Asian asset markets.

Seriously worried

Private bankers take the threat of higher inflation extremely seriously. It is “probably one of the key concerns we have for our clients worldwide given the low interest rate environment,” says Mark Andersen, co-head of asset allocation for UBS Wealth Management.

“Many clients would say their first priority is: ‘I would like to keep my purchasing power’. For them, that’s what it’s really all about.” Between now and 2020, Mr Andersen expects average inflation of 2 or 3 percent in the US compared with only 1.6 per cent now, and “2 percent or so” in the eurozone – at the top of the ECB’s target range. Private bankers broadly agree with these estimates, though forecasts of UK inflation have recently been thrown into turmoil by Mr Carney’s comments.

High net worth investors nervous about inflation should invest in “real assets – stuff you can kick and feel”, says Jeffrey Mortimer, Boston, US-based director of investment strategy for the wealth management division of BNY Mellon. This includes commodities and real estate.

However, Paul Marson, chief investment officer for private banking at Swiss stalwarts Lombard Odier, dismisses the old belief that commodities are a hedge against inflation. “This is true only under very specific circumstances,” says Mr Marson. “They were a good hedge in the 1970s, but only because the inflation of the 1970s was caused by commodities.”

While many private bankers continue to value gold as a sentinel against inflationary destruction, Richard Jerram, chief economist at Bank of Singapore, is sceptical. “Gold prices have tripled, but prices in the rest of the economy” – against which gold is a hedge – “aren’t likely to triple.” The price of an ounce of gold tipped above $500 (€386) in 2005, and was trading at close to $1,600 in mid-March.

Most private bankers see, like Mr Mortimer, some virtue in the hedging capabilities of real estate. These include Baer’s Mr Gattiker, who describes the German real estate market as “a sleeping beauty, which hasn’t yet been bid up by excessive speculation”.

But many warn that large parts of the market have, like gold, already been overbid by investors keen on its inflation-proof properties. Mr Jerram cites the boom in Hong Kong real estate as an example of a more general phenomenon across asset classes. “There aren’t any cheap choices to hide in anymore,” he explains.

John Tsang, Hong Kong’s financial secretary, has warned of “the risk of an asset bubble” in the city state’s property market.

Private bankers also warn against long-dated conventional debt, whose price falls in response to higher inflation expectations. Some are wary of inflation-linked bonds too.

The trouble with ‘linkers’ is that many investors have got there already, in response to price fears – pushing rates on UK and US inflation-linked bonds, for example, into negative territory. Because of their negative yields, Mr Duret of ABN Amro cites inflation-linked bonds as one of several “traditional tools which are not appealing as insurance against inflation” – with gold as another example.

Defensive stocks

With so many of the alternative inflation hedges so highly priced, wealth managers are increasingly interested in the protection offered by equities.

Academics at London Business School have found equities are likely to generate inflation-beating returns when inflation is in “a low to mid-single-digit range”. The work by Elroy Dimson, Paul Marsh and Mike Staunton, based on 112 years of data, was published by Credit Suisse.

Wealth managers must, however contemplate the crack in equities’ protective coating against rising inflation: what happens if moderate inflation breeds expectations of further inflation, producing a wage-price spiral that pushes the rate up ever further?

“When I talk to our customers about runaway inflation, that’s something they really care about,” says Mr Andersen of UBS. “If inflation was half or one percentage point higher they wouldn’t worry too much, but runaway inflation is scary.” He adds that this “is a clear risk for client portfolios” over the next five to 10 years.

“Clients face the question of whether the printing of money by central banks will mean losses to their wealth in real terms, because of inflation,” says Mr Gattiker of Julius Baer. “A lot of clients are trying to protect themselves against this future depreciation, because there might be higher inflation down the road beyond the next 18 or 24 months.”

Considerably higher inflation would, believe strategists at UBS, force central banks to raise interest rates considerably, hitting corporate earnings and share prices. In such circumstances the bank would recommend stocks in companies producing the most essential consumer goods, such as food and toothpaste.

ABN Amro’s Mr Duret says equities are a good hedge against inflation “only up to a certain level – 3.5 or 4 percent max”. After that, high inflation raises costs, erodes margins, and conjures up unpredictable winners and losers from the sudden shifts in prices. “High inflation creates uncertainty, and that requires a high equity risk premium. That’s the end of the game,” says Mr Duret with stark finality.

Short-term debt

Another approach to runaway inflation, used at UBS, is to make short-term corporate debt with maturities of between one and three years a cornerstone of the portfolio. It offers yields ahead of highly rated government debt, and is less sensitive to increases in inflation than longer-term bonds because the debt is continually reissued at coupons which reflect prevailing inflation and interest rates.

Buying short-term debt as an inflation hedge fits the current needs among investors across the world, says Nikko’s Mr Wang. In previous eras they responded to the prospect of higher inflation by exiting bonds, “but the investor class today is much older, so income investing is a long-term trend”.

Some wealth managers assert, however, that it is too early for wealthy investors to worry about inflation – and that excessive fear would distort investment strategies and damage returns. “I don’t see a huge risk of high inflation for the next 12 to 18 months in developed markets, because the output gap remains very high,” says Cesar Perez, chief investment strategist for Europe, the Middle East and Africa at JP Morgan Private Bank. “This makes it very difficult to believe there will be strong wage growth.”

Mr Perez adds that “countries can afford a bit of inflation – 2, 2.5 or 3 percent would be fine.” These comments would brand him a heretic among traditional inflation hawks. They put him in the same camp, however, as the Bank of England’s monetary policy committee, which made clear in February that a persistent overshoot of inflation above its 2 per cent target was acceptable for the next few years.

BNY Mellon’s Mr Mortimer says his clients’ portfolios are currently underweight in inflation hedges such as commodities and inflation-linked bonds. “We have very limited inflation protection because we don’t see inflation as an immediate threat.” He argues that since commodities not only offer no yield but even incur storage costs, investing in them too early depresses returns.

Lombard Odier’s investment team is also fairly relaxed about the possibility of consumer price rises. They point out that at 24 percent, investment as a share of global GDP is at its highest point in 24 years, pointing to an extremely wide output gap that suppresses price inflation.

The bank’s Mr Marson concludes, however, that because of central bank easing, “I think we are seeing runaway inflation already – in asset prices.” He cites the high valuations and low equity risk premia of the US stockmarket. In Mr Marson’s eyes, central bank easing is creating a different kind of inflationary beast to keep wealthy investors and central bankers’ children awake.