Threadneedle sees trouble ahead for UK economy

Threadneedle has increased its estimates for UK inflation and interest rates, pointing to difficult times for the domestic economy.

Head of Government Bonds at Threadneedle, Quentin Fitzsimmons, explains that the Bank of England's interest rate options are limited: "If ‘nice' as used by Mervyn King is a mnemonic for non-inflationary continuous expansion, then the first half of the mnemonic is a thing of the past. We are in an inflationary phase now and, with the Bank of England's mandate focused solely on inflation, further rate cuts from here seem extremely unlikely."

High fuel and food prices have been the key drivers of inflationary pressure lately, and Fitzsimmons sees little respite here. "The oil price probably has some speculative premium built into it but, even taking this into account, we don't see oil going below $100 a barrel over the short, medium or long term," he says. "And, given where we've come from, anything above $90 over the next six months will continue to be inflationary. We've raised our inflation forecast to 3% for this year."

The cocktail of rising food and energy prices and falling house prices does not bode well for economic activity, as Fitzsimmons highlights: "With the housing market weakening and wage increases muted, consumers are going to feel the pinch, and so are those parts of the economy that have been buoyed by the consumer boom. Consumer and business sentiment is likely to deteriorate further, and this makes for a worrying growth outlook. We are not forecasting a recession, but our GDP growth estimates of 1.5% for 2008 and 2009 are well below trend."

If this makes difficult reading for consumers, Fitzsimmons sees opportunities at an investment level. "Rising inflation is not good news for a traditional bond fund manager," he admits, "but more sophisticated funds that take advantage of the UCITS III regulations can make money in these conditions."

By using derivatives, managers of UCITS III funds such as the Threadneedle Absolute Return Bond Fund can tailor their strategies to match their views with great precision. "Changes in interest rate and inflation expectations lead to changes in the shape of the yield curve," explains Fitzsimmons. "We can target these changes very accurately with the range of instruments at our disposal. We can also make money from rising yields across the curve, which would be a nightmare scenario for a traditional manager."