Investment Committee: What are the prospects for inflation?

Chairman Beth Brearley, Editor, Fund Strategy

Last month the Office for National Statistics revealed that Consumer Price Index inflation overshot the Monetary Policy Committee’s 2 per cent target in February, jumping from 1.8 per cent in January to 2.3 per cent.

Rising fuel and food prices were the main drivers, with each contributing around 0.1 percentage points to the headline rate, while sterling’s depreciation also played a part.

The shock rise marked the highest rate since September 2013, and means inflation is now higher than earnings growth, at 2.2 per cent. With consumer spending key to the economy, the hit to real pay could prove problematic.

Opinion is divided on inflation for the rest of 2017. Some economists expect it to average 3 per cent, while the Office for Budget Responsibility forecasts that it will rise to 2.4 per cent in 2017 before falling back to 2.3 per cent in 2018 and 2 per cent from 2019.

A survey by Citi and YouGov conducted in March shows the public expect inflation to be 2.5 per cent in a year’s time, down from the 2.6 per cent predicted in February. Meanwhile, the inflation forecast for five years ahead fell for the first time since July, from 3.2 per cent in February to 3 per cent in March.

At the latest MPC meeting only one member voted for an interest rate rise, but could we now see others taking a more hawkish stance? And where does this inflationary environment leave investors, who may struggle to generate real returns in fixed income? Will we see a shift in asset allocation towards equities?

John Husselbee, Head of multi-asset, Liontrust Asset Management

It is little surprise to see inflation on an upward trend in the UK, with oil prices rising and sterling continuing to slide. While Brexit has been a factor, sterling has been falling for at least 18 months.

Against such a backdrop, UK inflation rose to 2.3 per cent in February and there are questions about how much further it can climb. If we look back to the last time sterling devalued, in 2008/2009, we could see inflation push through 3 per cent and even touch 4 per cent but I believe any such rise would be a spike rather than a sustained increase.

Whatever happens with prices, Brexit uncertainty means the UK remains near the back of the queue when it comes to interest rate rises; were it not for that, we would already be following the Fed down the rate-hiking path.

Many are talking up the benefits of index-linked debt to counter inflation but we believe it is more complicated. Stronger economic growth tends to favour short duration assets and as index-linked debt is typically a longer duration play, it may not be the inflation solution many believe.

Tim Cockerill, Investment director, Rowan Dartington

Inflation and central bank action are theoretically linked in a straightforward way; inflation up means rates up. And with inflation expected to reach 2.8 per cent next year that should be a signal to raise interest rates.

Nothing, however, is quite that simple. Inflation can be broken down into its core components, and unless inflation is being driven by demand then there is a case not to raise rates. The Bank of England has said as much, that it will look through the base effect of the oil price having recovered and sterling’s fall.

In fact the key statistic is wage inflation, which remains subdued. Wages are growing but not quickly and with inflation rising the rate of real wage growth is being squeezed and could turn negative next year.

Equities are a good inflation hedge. Assuming inflation doesn’t become too high, businesses can pass costs on in many cases and while this has not been something they have done in the recent past, a period of higher inflation will see this begin to happen again.

Peter Lowman, CIO, Investment Quorum

The prospect of higher UK inflation has dominated asset allocations over the last six months, as rising food costs and fuel prices has helped push inflation to its highest level for a number of years.

Arguably, in the UK the sharp fall in the pound is likely to drive the rate of inflation even higher throughout 2017 and 2018. Other forces at work could come from our exit from the European Union.

In respect to monetary policy, it is unlikely that the Bank of England will raise interest rates until 2018, at the earliest, even though they have upgraded their UK economic growth rates very recently.

Clearly, tilting portfolios towards inflationary protection assets would be prudent; index-linked bonds, infrastructure and UK equity income funds could be a wise strategy to take at this stage. However, if we were to see a weakening of either UK or global productivity growth then we might see a return of disinflation, which would again see a turnaround of asset allocation.

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Mike Deverell, Investment manager, Equilibrium Asset Mgmt

We have been concerned about inflation in the UK ever since the EU referendum. The falling pound and recovering oil price in particular are pushing up prices. When we look at the breakdown of inflation we can see that transport costs are the biggest contributor, whereas this time last year this was having a deflationary effect.

In addition, prices of food and non-alcoholic beverages are now rising after several years of deflation, mainly due to increased import costs. This could have an impact on the UK economy since prices are rising faster than wages.

The good news is this could be a temporary phenomenon. Oil has essentially doubled in value over 12 months, while the pound is down 15 per cent against the dollar since the EU referendum. These moves are unlikely to be repeated over the next year and so inflation will eventually drop back.

However, given the uncertain Brexit picture, holding index-linked gilts in the short term would be good insurance against any further falls in the pound and a slowing UK economy.

James Calder, Head of research, City Asset Management

As many of our mandates have an inflation plus target, the February figure was a surprise in terms of rate of increase but not of direction.

The year-on-year rise in commodities, and in particular oil, combined with sterling depreciation impacted quicker than expected on the rate of inflation. The MPC’s latest view on rates was prior to this data announcement (they would not have had prior sight), so one should wonder if this gives cause for more members to become hawkish.

In my view rate rises in the UK over 2017 and into 2018 are unlikely given the forthcoming Brexit negotiations.

I believe it is also important to note that this current burst of inflation is likely to be transitory. The inflation rate rebases each year and I am of the view that oil is unlikely to make substantial new highs this year. In fact, recently the price has begun to dip back. Sterling appears to have found a floor versus the US dollar, but it is the wild card with regards to inflation.

John Redwood, Chief global strategist, Charles Stanley

As expected, UK inflation has risen in line with US and German inflation. The single biggest cause was the rise in oil prices affecting transport costs. Hotels and restaurants also put up prices reflecting good demand and wage and other cost pressures following the introduction
of the living wage.

We expect inflation to go up a bit more. The recent falloff in the oil price, continuing intense retail competition and overcapacity in various world manufacturing areas will continue to limit the increase. However, we do not expect to see a major surge based on lower sterling. The pound started its fall as long ago as July 2015, and so far UK inflation has stayed below US inflation, which has benefitted from a strong dollar.

Market expectations are for future inflation of around 3 per cent. This level of inflation does not cause us to rethink. The Bank of England has said it will be looking for higher wage inflation before it moves on interest rates. We think the Bank may need to raise rates by 0.25 per cent in due course to avoid undue pressure on the pound.

Independent view, Russ Mould, Investment director, AJ Bell

Inflation has finally reached the Bank of England’s 2 per cent target, at least using CPI and the CPIH as benchmarks, but it is by no means guaranteed that price rises will push on from here, despite the ongoing QE programme and record low interest rates.

In the short term, much of the rise in inflation is due to increases in crude oil and salads (owing to the harsh European winter), as well as the weaker pound.

Oil has stopped going up – and if it stays around $50 it will stop adding
to inflation come the autumn. Summer is coming to help out European farmers and even sterling has stopped going down.

In the longer term three hugely deflationary (or at least disinflationary) factors are still at work: debt (which is higher globally than it was in 2007), demographics (we spend less as we age) and the internet, which brings price-crushing transparency to an ever-growing range of industries.

As such the Bank of England is likely to move slowly, if at all, to raise rates in the next one to two years. This is something the gilt market is already telling us as 10-year yields retreat to 1.15 per cent and the yield curve flattens again as the gap between two and 10-year gilts closes.

The forces of disinflation look to be every bit as strong as those of inflation, if not stronger. Keeping some fixed income element to a portfolio therefore makes sense, while long-term investors will look to equity income as firms with good dividend records tend to have pricing power.