Yarrow, who heads up the five crown-rated Evenlode Income fund, has moved to protect investors from both possible scenarios.He believes inflation is "inevitable" in the long-run, but given the threat of deflation in the shorter-term, he says it would be unwise to back one scenario over the other.
"Most assets either do well in an inflationary environment or a deflationary environment," he said.
"Companies that deliver a high return on equity, without using a lot of debt, and that focus on strong, intangible assets and brands, tend to do well in both."
"Crucially, they have good pricing power. They can sell things even if their prices go up – think PG Tips and Colgate, for example."
"However, they also fare well in a deflationary period. They tend to offer resilient, repeat-purchase products, which people can’t do without."
"I don’t want to predict which way [inflation or deflation] goes. I’d rather insulate against it either way."
Yarrow says that the continuous process of quantitative easing will inevitably cause inflation in the long-run, but believes the deleveraging process could cause deflation in the shorter term.
"We could get to a point where we get serious inflation over the next decade," he said. "I can certainly imagine a scenario where we go back up to the 5 per cent level [in the UK]."
"This would seriously erode the real wealth of assets, but businesses that sell goods that consumers always need are best insulated from this risk."
"In the shorter term, I wouldn’t want to make this bet though. There’s no reason why both [inflation and deflation] can’t happen at some stage."
He says a lot of companies that produce consumer staples have particularly good pricing power and points to Coca Cola as a good example.
"The product hasn’t really changed in the last 50 years and it probably won’t for the next 50," he explained.
"It doesn’t have much capital expenditure, because the product is always the same. It’s a nice one to own because most of the profit is converted to cash and given back to the shareholders in the form of a dividend, or through share buybacks."
"I also like a lot of companies in the healthcare and specialist engineering sectors, which have high levels of intellectual property," he added.
Unlike many of his competitors, Yarrow believes valuations in consumer staple industries are reasonable, despite their very good run in recent years.
"People go on about Unilever being on a high price-to-earnings ratio, but it always has been," he said. "Ten to 12 years ago, when the company wasn’t as good as it is now and had taken on a lot of debt, it was trading at 18 times, which is what it’s on now."
"It’s grown 11 per cent per annum since then. The point is, these companies can deliver a good return without their P/E ratio going up."
Yarrow says he completely avoids sectors that invest in tangible assets, including mining & oil, utilities and property.
He also has nothing in banks.
"I don’t have a macro view on them – they’ll just never be in the portfolio," he said. "Banks can only – by definition – generate a high return on equity by raising their levels of debt."
Yarrow’s stringent quality criteria means that he has a universe of only 85 stocks to choose from, across the entire market cap spectrum. While he invests predominantly in the UK, some of the 85 are international companies.
"I can invest up to 20 per cent outside of the UK and I have no problem in doing so," he added.
Yarrow invests in approximately 30 companies. He picks these from the 85 on a valuation basis.
His process has worked well so far; according to FE data, Evenlode Income is a top-quartile performer since its launch in October 2009, with returns of 52.69 per cent.
Performance of fund vs sector and index since launch
Source: FE Analytics
The fund has also beaten its sector and All Share benchmark over one and three years.
As well as performing strongly on a total return basis, Yarrow’s fund has been significantly less volatile since its launch and held up better during the 2011 sell-off.
According to FE data, in a sector comprising almost 100 funds, it is the sixth-least volatile since October 2009, with an annualised score of 10.58 per cent. By contrast, the All Share has an annualised volatility of 13.69 per cent.
In spite of Evenlode Income’s stellar start, it is still just £19m in size. Yarrow explains that this flexibility has been a big driver of performance, as he has been able to move up and down the market cap scale with ease.
"When the fund launched, we saw a lot of quality in small and mid caps, which have since outperformed very strongly," he said.
"In 2009, we had 45 per cent in large caps and the rest in small and mid caps. Now we are invested predominantly in large caps, because this is where we see value."
"We would be very happy to go back to buying small and mid caps in the future. However, at the moment dividends are not as attractive and there isn’t as much free cash-flow."
This view is in direct contrast to Old Mutual’s Stephen Message, who told FE Trustnet earlier this week that the mid cap market is the most attractive area for dividend growth in the UK.
Yarrow holds UK blue chips Unilever and GlaxoSmithKline, as well as US-listed consumer goods company Procter & Gamble.
He also has big stakes in smaller companies, including Halma, Halfords and Atkins.
"From a marketing perspective, it would probably help if we were a small cap focused fund, because it would mean we were a bit different," Yarrow said. "However, the fact is we see large caps as the most interesting area at the moment."
Yarrow says he would only start to worry about running the fund with the same level of flexibility once it got to £500m in size.
Evenlode Income requires a minimum investment of £1,000 and has a total expense ratio (TER) of 1.73 per cent.