LONDON Fears that governments will raid the savings of citizens to reduce debt burdens are driving investors to take greater risks with their money to outpace erosion of their wealth, leaving them more exposed to losses in the financial crisis.
Interest rates kept below inflation in developed economies are a common method for governments to reduce debt burdens, known to economists as a form of 'financial repression'.
By allowing the value of money to erode, they help out debtors, including themselves as sovereign borrowers, reducing the size of the debts without the need to impose harsh fiscal measures like tax increases.
"It's the feckless effectively being bailed out by the prudent," said Rob Burgeman, a divisional director at investment manager Brewin Dolphin (BRW.L), who sits on the asset allocation committee.
Money managers are thus faced with a dilemma. Their clients are willingly putting their nest eggs at greater risk in an attempt to outrun the governments that are effectively plundering their savings.
So they are investing, albeit reluctantly, in riskier assets such as stocks in the hope of preserving value against inflation, and the seriousness of the financial crisis means these riskier investments are riskier than ever.
"The challenge at the moment is how to navigate portfolios with on the one hand a long term view that there's a lot of financial repression and you don't want to have your pocket picked," said Myles Bradshaw, London-based portfolio manager at PIMCO.
"And on the other hand (there is) a lot of short term risk that the policy response in Europe continues to be insufficient so you are focused not on the return on your capital, but the return of your capital".
Consumer price inflation in the UK stands at 5 per cent, having reached a three-year high of 5.2 percent in September. Interest rates are at a record low 0.5 percent.
While equities are widely regarded as an effective hedge against inflation, they have trended lower in recent months, and remain volatile.
Wall Street's so-called fear gauge, the VIX index .VIX, which measured market volatility, is currently at around 34, twice as high as where it started the year, though still well below the peaks above 80 reached during the 2008 crisis.
The conundrum has led to a sense of exasperation among both institutional investors and the retail clients of investment houses, fund managers say.
Richard Marwood, portfolio manager at AXA Investment Managers, said individual savers were moving further into equities, sometimes for the first time ever, while pension schemes were also looking at their allocations.
"I was meeting a (pension) scheme yesterday and they were expressing the same kind of dilemma as to what they can do. The bond market is looking expensive. Cash is definitely losing value in real terms but the equity market is so volatile. It's just not easy," he said.
Brewin Dolphin's Burgeman says financial advisers are now spending more time warning their clients about the greater risk of losing their money if they act too aggressively in their quest to outpace inflation.
"We joke about having to hose potential clients down with flame retardant - you have to manage that sense of expectation - you could see 1,000 points knocked off the market," he said.
Some in the investment industry believe financial repression is likely to be short-lived, however, as the current crisis poses a greater risk of deflation than persistent inflation.
Gervais Williams, a fund manager at MAM Funds said banks shoring up their capital reserves to protect against the European debt storm translates into less money lent to businesses, which puts the brakes on economic growth.
"Even orderly winding down of balance sheets and repayment of debt is deflationary. The reason we're seeing such little (economic) growth is because the banks' balance sheets are being reduced and we're not seeing much lending going on," he said.
(Reporting by Chris Vellacott; Editing by Andrew Callus)