Annual inflation as recorded by the UK retail price index (RPI) stood at 5.1% in January. The consumer price inflation (CPI) index, which does not include mortgage interest payments and some other costs registered by the RPI, is currently running at an annual rate of 4%, double the Bank of England’s official inflation target rate.
Following the onset of the financial crisis, the policy tools deployed by central banks and governments battling to stave off recession, namely significant injections of liquidity and quantitative easing, have brought interest rates to historical lows but have also raised inflationary expectations.
The traditional view is that investments in equities or commodities provide a portfolio with implicit positive correlation to inflation. Certainly, much of the recent inflation has been driven by rising commodity prices. The increasing price of soft commodities has pushed up the cost of food, while the upward trajectory of the oil price has made petrol and diesel more expensive at the point of purchase. Meanwhile, equity investments have traditionally been thought of as a hedge against inflation on the basis that company shares represent a claim on the dividend stream of real assets, with the result that companies will pass inflation on to their clients in the form of higher prices, at least in the long term.
However, some academic researchers suggest that assets such as commodities and equities are far from reliable inflation hedges. In 2009 researchers from the International Monetary Fund* examined the performance of a range of traditional asset classes – equities, cash, bonds and commodities – in the wake of historic inflation shocks. “Among traditional asset classes, inflation hedges are imperfect at best and unlikely to work at worst,” the researchers concluded. They found that equity returns tend to decline in the months following an inflation shock and “do not experience a meaningful recovery thereafter”. They also found that, although commodities tend to be the best performing asset class over the short term following an inflation shock, over the longer term commodity prices start to fall.
Not surprisingly, the researchers found that fixed income instruments are the worst performing asset class in the immediate aftermath of an inflation shock – because inflation negatively impacts the purchasing power of a fixed income asset.
Partly because commodities and equities have come to be seen as at times offering ineffective protection against inflation, a number of products have emerged in recent years designed to give professional investors a more precise inflation hedge, or indeed to single out inflation itself as an asset class for speculative purposes. Inflation swaps and inflation options have become increasingly popular in the US and Europe, but these markets may not be accessible to those with investment mandates that prohibit investing in derivatives. Inflation-linked bonds have also become more prolific. However, for investors primarily concerned with inflation, interest rate hikes – which could be expected on the back of rising inflation – reduces the price of inflation-linked bonds, leading to mark-to-market losses for those already holding long positions.
An easy-to-access and useful alternative for inflation-wary UK investors is the db x-trackers UK Gilts Short Daily ETF, which provides inverse exposure to movements in the UK Gilts markets. It does this by replicating the performance of an investor with a short position, which is rebalanced daily, on the established UK Gilts Index. As such it provides an implicit hedge against both inflation and interest rate hikes – the impact of inflation and interest rates on a short bond index is the opposite to their effect on a regular bond.
Meanwhile, the ETF format lets investors express their view on falling bond prices connected to rising inflation expectations without directly investing in derivatives.
On a daily basis, the performance of the Short Gilts Index is the negative performance of the Gilts Index plus a prorated portion of interest based on two components: the Sonia (Sterling Overnight Index Average), and a predefined Repo rate. The Gilts Index represents overall GBP sovereign debt issued by the UK government, covering all maturity buckets.
db X-trackers prides itself on the efficiency and accuracy of its tracking, and the db x-trackers UK Gilts Short Daily ETF is no exception. The graph at the bottom shows performance since inception of the ETF, and the accuracy with which the ETF tracks the index it is designed to replicate.
As well as the Short Gilts ETF, db X-trackers also offers an ETF that provides a daily short position in the iBoxx Sovereign Eurozone Total return Index, covering the government bonds of the Eurozone area, and also an ETF that offers a daily short position in US Treasuries, the db X-trackers US Treasuries Short Daily ETF. db X-trackers is the only ETF provider globally to offer a short UK Gilts product.
