Investment Committee: What path will UK inflation take?

brearley-beth-_700x450

Committee chairman
Beth Brearley, features editor

September saw the highest rate of UK inflation for nearly two years. Figures from the Office for National Statistics show Consumer Price Inflation reached 1 per cent, up from 0.6 per cent in August and the highest level since November 2014.

The higher oil prices seen this year and fall in sterling have been big contributors. Sterling plummeted following the UK’s vote to leave the EU and continues to struggle, dropping to its lowest level against the dollar in 31 years last month and falling 6 per cent against the dollar over the course of October, marking its worst month since June.

The Bank of England’s current inflation target is 2 per cent, but it is well within the realms of possibility that CPI surpasses this next year. Indeed Bank of England Governor Mark Carney has said he will “tolerate a bit of an overshoot in inflation”.

Another signal of an inflationary environment is the 10-year break-even inflation rate, which is currently above 3 per cent. However, while well-regarded fund manager Neil Woodford says he expects inflation to rise slightly above 2 per cent over the coming year, he caveats this by saying deflation remains more of a concern to him than inflation over the longer-term.

What path will UK inflation take going forward? What impact will it have? Conventional gilts are out of favour and inflation-linked gilts are in, but where else should investors be looking to avoid or take advantage to inflation-proof their portfolios?

John Husselbee Liontrust Husslebee

John Husselbee
Head of multi asset
Liontrust

Due to the post-referendum fall in the pound and the growing inefficacy of quantitative easing, we are now seeing (predominantly imported) inflation and, as a consequence, rising interest rate expectations. One of the biggest consequences has been a sell-off in bonds.

We have seen bond yields back up before, only to subsequently resume their multi-year bull trend. But yields are now so low that the asset class on a standalone basis looks one of the most expensive ever, so it seems likely that we may have reached an inflection point. This is a concern for investors as government bonds have been one of the most popular traditional ‘safe havens’ from market volatility, offering diversification and downside protection benefits. But with yields rising, bondholders are now experiencing substantial mark-to-market losses.

We argue that the asset class’ diversification benefits still justify an allocation in a balanced portfolio, but we have maintained our longstanding underweight position. Investors now have to look to other means of generating income and low-volatility returns, with the options including real estate, long/short equity strategies and strategic bond funds.

WEB_DecJan_Cockerill, Tim

Tim Cockerill
Investment director
Rowan Dartington

After many false dawns inflation is back and we expect it to rise sharply as the impact of sterling’s devaluation hits home. Already prices at the pump have jumped and are around 20 per cent higher than only a short while ago. This will suck billions out of consumer’s pockets and impacts the cost base for most businesses, so you’ll get a double hit. Consumers have less cash to spend and have to pay more for goods.

We expect some companies to hold back from increasing their prices to grab market share, but this is only likely in the short term, after which they too can be expected to put prices up. In addition there is the base cost effect of rising oil and commodity prices; cost increases that will wash through the economy.

The UK’s inflation outlook is worse than for most other countries because of the currency devaluation and there is a risk gilt yields will rise as confidence in the UK economy falters as the Government stumbles along with no Brexit plan.

Equities may be considered the risky asset class, but in this unfolding environment might just be the best hedge against inflation.

lowman-peter-2016-cut

Peter Lowman
CIO
Investment Quorum

Inflation rose to 1 per cent last month and is expected to rise above the Bank of England’s 2 per cent target over the coming 12 months.

Clearly, the collapse of sterling since the European referendum result, has been the primary reason for this increase given that imports into the UK such as petrol, food, and certain consumer products have now become nearly 30 per cent more expensive since the referendum and more importantly since the summer of 2014 when the £/US$ rate was nearer 1.7.

In recent comments from the Bank of England governor, Mark Carney, it would appear he expects the rate of inflation to continue to rise against a backdrop of further weakness in sterling and a “hard Brexit”.

It would be prudent for investors to position themselves for such events by having a meaningful exposure to index-linked gilts and companies that are able to pass on any increased costs to the consumer such as utilities, healthcare and commodities.

On the flip side the weakness in sterling should benefit UK exporters that could see their corporate profits and dividends rise above the levels of any inflation risks.

Deverell-Mike-2010-700x450.jpg

Mike Deverell
Investment manager
Equilibrium Asset Mgmt

Inflation is likely to significantly increase as a result of the falling pound.

‘Marmitegate’ is a warnings of things to come. Unilever’s costs are increasing. Tesco does not want to pay higher prices as they are engaged in a price war, but ultimately these costs will likely be passed onto consumers.

At present, food and non-alcoholic beverages are the biggest detractor from headline inflation but this looks set to reverse. Transport costs were a big detractor from inflation in 2015 due to the low oil price, but are now a net contributor.

Oil bottomed at around $27 a barrel in January. In sterling that was around £20 a barrel. It is now £42 a barrel, 110 per cent higher. As time moves on that will have a big effect on inflation which looks set to move to at least 3 per cent. Unless wage growth increases this could impact on consumer spending.

In portfolio terms, we believe holding inflation linked bonds makes sense right now. We are also avoiding conventional gilts, where you will lose money in real terms if held to maturity.

WEB_DecJan_Calder, James

James Calder
Head of research
City Asset Management

The impact of sterling’s collapse post Brexit has started to feed through to the inflation numbers and will continue to do so in the medium term (although there may be some respite as the base line re-sets at the beginning of each year).

However inflation was likely to rise through 2016 due to other pressures, not least of all the rally witnessed in the oil price. Our multi-asset approach has inflation at the core of its investment objective and we therefore believe that a mix of assets will provide inflation plus returns over an investment cycle. Nevertheless we have purchased listed infrastructure that invests in real assets that have implicit inflation protection built into their underlying cash flows. In other words, the contracts for the provision of the assets have inflationary uplifts to protect their yields against the real decline that would otherwise be apparent. This type of contract is common among this asset class and can be found within the renewable space and some quasi-property investments. Examples of this would include the closed ended vehicles: John Laing Environmental Assets and International Public Partnerships.

John Redwood

John Redwood
Chief global strategist
Charles Stanley

Markets assume UK inflation will rise a bit as the effects of the lower pound work through. The UK’s imports will be dearer over the months ahead, but it takes time for the effects to be felt. Importers have often bought at fixed prices and with currency protection for some time forward. Some will take a reduction of margin rather than push up prices as UK retail remains very competitive. Some will find domestic substitutes for imported products that can also cushion the effect. Many of our portfolios have benefitted from holding some inflation-linked bonds that protect investors and from the overseas holdings where the currency fall has directly advantaged investors. The Bank of England expects the effect to be a one off, so it is not pushing up interest rates to retrain a general inflation. Indeed, it has recently cut rates and created more money despite the relaxation brought on by the prior fall in sterling. This in turn has helped sterling down further and will give more of a boost to prices.

mark-richards-jpmam-2016-cut

INDEPENDENT VIEW
Mark Richards
Global strategist,
multi-asset solutions
JPMorgan Asset Management

Inflation has been a problem in recent years because there hasn’t been enough of it. Disinflationary pressures have been partly due to commodity prices falling and partly due to excess capacity in the global economy following the global financial crisis. Lack of inflation fuels fears of deflation, despite lengthy and innovative attempts by central banks to stimulate growth and push prices higher.

However, UK inflation is seemingly at an inflection point, having risen to a near two-year high of 1.5 per cent last week. Unfortunately, inflation is not rising for the ‘right’ reasons as it is being driven by the sharp fall in the pound rather than above-trend growth reducing spare capacity. Sterling has declined by 16 per cent on a trade weighted basis since the UK’s vote to leave the EU and 22 per cent since November 2015.

Ordinarily, investors would protect themselves from higher inflation by making allocations to assets such as real estate but in this case the vulnerability of the domestic economy limits the appeal here. UK equities offer some protection from a weaker sterling since the majority of FTSE 100 revenue is generated from outside the UK. In one sense, equities can also be viewed as a real asset since dividends should rise with inflation.

UK gilts have performed badly of late as 10-year yields have doubled to 1.2 per cent in the past two months. However, we do not think they represent good value yet as we expect that inflation will continue to rise in coming months as the full impact of sterling’s depreciation materialises.