Mark Dampier: Your best defence against inflation

While the controversy around bankers' bonuses is dominating the financial news, a far more important question is in danger of being overlooked. Should we be worried about inflation or deflation?

There are good arguments on both sides, but as each scenario requires very different portfolios, it is an issue that needs careful consideration.

Although they won't admit it, the Government would probably like to see higher inflation – it's the easiest way for them to decrease the value of their crippling debts – and history suggests that this is the most likely outcome. This could cause problems; it is notoriously difficult to keep a lid on rising inflation, and the best method of doing so (raising interest rates) is tough when the economy is weak.

Indeed, with our economy still in the doldrums and unemployment likely to continue rising, we have to consider deflation as a serious risk also, and recent months have seen moves towards deflation.

One of the asset classes most susceptible to inflation is bonds, so I was especially interested to speak to James Foster this week. He manages the Artemis Strategic Bond Fund, which has made a dramatic recovery since the lows of 2008. He agrees that there is little evidence yet of real inflation. There is no demand in the economy, wage growth is at its lowest for years, and unemployment is still rising. There may well be a blip in inflation as we see rises in VAT, petrol prices and other energy prices coming through, but even so inflation is likely to fall back again in the second quarter of next year.

However, this does not mean we can forget about inflation, and Mr Foster actually believes we are sitting on a ticking time-bomb. This is based on the fact that we have had a massive monetary stimulus and the Bank of England has been printing money through its quantitative easing programme. What is more, interest rates are at an all-time low and sterling has been depreciating.

Mr Foster's view is that inflation will be much more of a problem by 2011, and the transition to higher inflation will be painful. It could be bad news for bonds, gilts and shares alike.

So what has Mr Foster been doing? Until recently he has been "shorting" the gilt market, which has broadly been the right thing to do. He has halted this strategy more recently as he expects gilts to rally over the next two or three months. He is also relatively negative on investment grade corporate bonds (at least those outside the financial sector) as they now yield little more than gilts and he doesn't see great value there.

Fortunately, the flexible mandate of his Strategic Bond Fund means he does have some weapons to help investors through this difficult time. As I have said, he can take "short" positions as well as use floating rate notes, which offer a better yield if interest rates rise without a corresponding fall in capital value.

He has some 30 per cent of the fund in high yield bonds, with his biggest weighting in the financial sector, which he still believes is undervalued. Although he admits that defaults will rise within the high yield sector, investors are still being compensated by a very attractive yield, and he believes the risks are worth the potential reward.

Generally speaking corporate bonds have enjoyed a fantastic 2009, but of course that must be set against a terrible year in 2008. Nevertheless most investors should be sitting on a profit now.

The dramatic rises in corporate bonds seen in 2009 are highly unlikely to be repeated next year, although the income remains attractive, so the sector should still appeal to many investors. Perhaps strategic bond funds, with their greater flexibility, could be best placed for an uncertain market in 2010. Other options for an increased income include the UK Equity Income sector. As I have said in previous columns, defensive shares and larger blue chips companies have on the whole been left behind.

Mark Dampier is the head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more information about the funds included in this column, visit www.h-l.co.uk/independent