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Fixed income asset allocation in times of inflation

Wealth DFM Magazine spoke to Andrew Eve from M&G Investments to discuss fixed income asset allocation and the various factors affecting it as inflationary pressures march on.

Plenty of times in the past investors have predicted, incorrectly, the return of inflation” says Andrew Eve, Investment Specialist for M&G Investments. But, Eve continued, unlike previous cycles, rather than just having one or two inflationary forces in the markets, we are now seeing several, all potentially working together in the same direction. In the short term, the most obvious inflationary pressure Eve sees comes from pent-up demand matched with stuttering supply chains, exacerbated here in the UK by Brexit. But, in the medium to longer term, perhaps the most significant factors are fiscal and monetary policy and the fact that they’re working together in a much more concerted way than we’re used to.

Reflecting back to the 2008 crisis, Eve comments “the expansionary monetary policies of central banks and the restrictive fiscal policies of austerity to some degree cancelled each other out.”

What he’s seen this time around, by contrast, is both monetary and fiscal policy being more expansionary, even before the 2020 pandemic. Eve cites early 2020, around the time of all the big fiscal announcements in the U.K. explaining, “The gilt market started to sell off in expectation of all this supply of bonds. And after a short sell off, the Bank of England came in and said effectively, we will buy them all. And you saw the Gilt market rally again.”

He continued, “That greater, albeit tacit, cooperation between governments and central banks is something that has changed and could be a lot more inflationary.”

In the U.S., Eve reminds us that the Fed has shifted tone too, moving to its average inflation targeting regime, and implying that they’re quite happy to be a bit behind the curve, rather than hiking rates too soon and risk spooking the market.

Structural change

In macroeconomic terms, other major aspects that may be beginning to change are some of the long term, more structural forces that have been in the economy over the past three or four decades, which Eve argues have been keeping inflation low.

One of these trends is the post-war generation, the biggest and richest in history. This significant cohort has invested solidly in income-producing assets as they get older.

Eve expanded, “I think, over the past 30 years or so, this has been a force keeping inflation a bit more muted and keeping interest rates on a more downward trajectory.”

Another long term, structural trend he points out is technology, which has enabled the automation of certain jobs, but kept downward pressure on wages.

Goods prices have been kept low as well through competition, access and price discovery given to consumers by the likes of Google and Amazon.

The final big structural shift he sees comes with retreating globalisation. Eve explains, “Even before the Covid pandemic, with US and China trade tensions for example, we were perhaps beginning to see a little bit of the end of this big period of globalisation. I suspect covid, if anything, will only have exacerbated that.”

Eve concluded, “My base case wouldn’t be runaway inflation, but I think it’s easier to make the case that we could see inflation running a little higher than perhaps we’ve been used to.”

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