As inflation rises, so can your profits

WHATEVER the Bank of England might be telling us about a temporary spike in inflation, fund managers and analysts around the City are preparing themselves for a period of rising prices and adjusting their portfolios accordingly.

Their reason? The parlous state of developed countries’ public finances combined with a weak recovery means that heavily indebted governments may be tempted to inflate their way out of their fiscal difficulties. As Morgan Stanley’s global economics team argue: “If high debt is deemed undesirable, but the political will for higher taxes and lower spending is lacking, then a soft default through inflation becomes a possibility.”

In the UK, the consumer prices index (CPI) is already rising by 3.5 per cent, well above the Bank of England’s 2 per cent target. A further acceleration in prices is expected over at least the next month or two. A combination of a depreciation in sterling, rising commodity prices and indirect tax hikes may not be as temporary as the Bank is hoping.

Spread betters should be taking note as well – asset classes perform differently in periods of relatively high inflation so you can improve your profit potential by selecting the right assets to trade.

Gold is normally the standard hedge against inflation because it retains its value over time. But with the precious metal at record highs and talk of a bubble increasing, gold might not be the best asset for spread betters trading on margin. Going long on bond prices is also not a good idea because interest rates will (eventually) go up to combat rising inflation and bond prices will therefore fall.

Stocks and commodities are the assets to trade in an inflationary period. Amit Lodha, manager of Fidelity’s Global Real Assets fund, said only last week that basic resources and oil and gas are the sectors most likely to perform best in a high inflation environment. His research found that when inflation is rising, European basic resources stocks beat the market all of the time while oil and gas stocks outperformed the market 80 per cent of the time. These stocks are also underpinned by emerging market growth, so are a good punt for a spread better.

Traders can also bet directly on the price of commodities to hedge their exposure elsewhere to assets that might suffer in an inflationary environment. Like gold, they are linked to inflation because of their tangibility and intrinsic value. Societe Generale research has found a close correlation between US inflation and the S&P Goldman Sachs Commodity Index and also shows that any breakdown in correlation should not be long-lived. This indicates that any hedging of inflation using commodity futures indices should be fairly successful.

Remy Penin, analyst at Societe Generale, says that crude oil may be one of the best candidates among the commodities to hedge against inflation. Agricultural commodities such as wheat might also be a good bet as food is a necessary and substantial part of any household’s expenditure. In a persistent inflationary environment, the chances are that the prices of agricultural commodities such as wheat and sugar will be rising.

Of course, if this all sounds a bit complex, spread betters can go for the simplest trade of all: spread betting directly on inflation. GFT offers markets in both European and UK inflation with a margin requirement of 5 per cent and a spread of five basis points on the nearest month contract and 10 points on any other months.

However, traders can only have a maximum position of £25 per account on this market so it might be more lucrative for spread betters to look at sector bets on basic resources and oil and gas.