Inflation is likely to remain well above the Bank of England's target in 2012, according to Stephen Jones, manager of the AEGON Inflation Linked Fund.
Jones, whose fund celebrated its first anniversary on 30 July 2011 having returned 11% to investors compared to an index return of 8.03%* and tripling in size to £161m** since launch, believes that despite the recent reassuring figures, the rate is unlikely to fall significantly in the near term.
"It is encouraging that the most recent inflation figure is slightly better than expected, with an average inflation Consumer Price Index level in the UK of 4.4% for Q2, relative to the Bank of England's prediction of 4.5%. Similarly, it is good that for the first time in a while they have managed to produce some sort of expectation that has been undershot. However, you can't ignore the reality of those absolute numbers - 4.4% relative to the 2% target that they should be aiming for, and is their primary objective."
According to Jones, inflation will still be a burden on the economy into next year and is unlikely to abate. "Looking into the rest of the year, inflationary pressure is still strong even into 2012," he says. "The recent energy price rises that have now percolated through from all the major suppliers - 10%+ in electricity and nearly 20% in gas terms - will offset any slight fall in petrol or food prices. And even there, the news is not particularly good in that, whilst wheat prices in the food complex have come off quite a lot, corn and soya beans and other said staples are very high still. So the picture of background pressure on inflation and a tough scenario for inflation into 2012 is very apparent to us."
On the back of his predictions, Jones is positioning the fund to continue protecting against these inflationary pressures, with some dividend paying equity and commodity exposure. "Within this scenario, we are continuing to orientate the fund towards index-linked protection, especially in agricultural soft commodities as the primary mix of assets in the fund."
As well as this, Jones has been adding to the fund's natural gas holdings in belief that usage could rise given the nervousness around nuclear power. "We continue to think natural gas is cheap relative to oil and that the usage of gas looks set to increase in the long term - especially for power generation - given European and other nations' caution around nuclear power development or production. We have been building a holding there for the long term, believing some of the wholesale price increases you see coming through in UK suppliers will be persistent, and that natural gas will rise in price from what's been very low and cheap levels.
Alternatively, if the scenario Mervyn King has predicted is correct, and inflation falls back towards target next year, Jones has the flexibility within the fund to re-position accordingly. "We can reduce the index-linked content, and will be keener to take conventional interest rate exposure in that sort of market place. We would also be quite sceptical of holding a lot of equity because a fall away in inflation would imply there is very lacklustre demand in the economy as well, and the recovery is stalling.
"On that basis we would reduce - or simply hedge with an overlay - the equity exposure in the fund, and we have taken both of these approaches over the last quarter. As growth expectations have slowed in Q2 2011, we looked to take a more conventional interest rate exposure in the fund and also, during periods of equity weakness, we have hedged equity exposure and protected some capital."
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