U.K. Inflation Threat Underestimated, JPMorgan Says

May 6 (Bloomberg) -- Investors underestimate the threat inflation poses to U.K. gilt returns, and should seek protection from higher consumer prices no matter who wins today’s election, according to JPMorgan Chase & Co.

Britain’s record budget deficit means the next government will be left with few options besides raising levies including the sales tax, which will push consumer prices higher, Jasper Falk, the bank’s global head of inflation trading, said in an interview. Investors should still “keep buying protection” such as index-linked bonds or swaps because the Bank of England will likely be forced to keep its benchmark interest rate at a record low to foster the economic recovery, Falk said.

“There is potentially going to be a knee-jerk reaction in the bond market after the election, but beyond that I see a major move in inflation,” Falk said. “All three parties are being criticised for not addressing the deficit more explicitly. But one thing they are likely to do if they become the next government is to raise taxes. You are likely to see a spike in short-term inflation.”

JPMorgan’s latest survey in March showed more respondents expect British inflation to be above the central bank’s target of 2 percent in two to five years. In the euro region, an increased number of investors expected below-average inflation.

Prime Minister Gordon Brown and his rivals, Conservative leader David Cameron and Liberal Democrat chief Nick Clegg, have been trying to persuade voters their policies are best to tackle a budget gap that widened to 11.5 percent of gross domestic product last year, the biggest among the Group of Seven nations.

Consumer Price Growth

U.K. annual consumer-price growth accelerated to 3.4 percent in March, data released on April 20 showed, near the 14- month high of 3.5 percent reached in January. Inflation expectations, as measured by the 10-year yield difference between regular and index-linked bonds, were little changed from the level at the start of the year, standing at 295 basis points as of 2:15 p.m. in London.

In the euro region, the crisis engulfing Greece and the risk that it might spread to other indebted nations, such as Portugal and Spain, may lead to a decline in inflation, Falk said.

The JPMorgan survey, which the bank said is monitored by central banks including the Federal Reserve, the European Central Bank and the Bank of England, showed 66 percent of respondents expect U.K. inflation to be above target, compared with 57 percent in the previous report in November. Of the total, 17 percent expect consumer price growth to be “significantly” above 2 percent.

‘Tale of Two Cities’

By contrast, 17 percent of respondents said inflation in the 16-nation euro region will fall “below average” in the medium term, compared with 12 percent in the previous survey. Some 52 percent of investors in the survey expect inflation in the region to be close to target.

“The inflation story in the U.K. and the euro zone is a tale of two cities,” said Falk. “The shift we’ve seen in our latest survey is the softening of expectations in the euro area and the hardening of expectations in the U.K. What might have prevented a sell-off in the euro-zone inflation market is probably concern over potential tax increases in the near term.”

British index-linked bonds underperformed both U.S. Treasury Inflation-Protected Securities (TIPS) and German inflation debt, returning 2.5 percent compared with 3.1 percent from TIPS and 3.3 percent from German securities, according to Bank of America Merrill Lynch’s indexes.