Various forces are conspiring to push UK inflation higher, here we discuss these and the investment implications of accelerating price rises.
Given current economic headwinds, some have suggested that the era of extremely low interest rates and inflation is here to stay. However, a number of factors suggest that UK inflation is set to rise from its current subdued level. If it does, the adverse impact it will have on the purchasing power of people’s savings will intensify. We note that in 1970s Britain, the average annual rate of Retail Price Inflation (the Bank of England’s (BoE) preferred inflation measure) was over 12% and this rate was sufficient to reduce the spending power of a pound by around two thirds in just one decade. Although we think it is highly unlikely that inflation will reach these levels again in the near future, a more minor rise will still require investors to take steps to mitigate its negative effect on their wealth.
Notwithstanding a dramatic recovery, the key driver of higher UK inflation will be the recent devaluation of sterling, which has occurred amid perceptions that the region’s future trading options with the EU might be reduced. However, there are also numerous global factors that will provide further support to UK inflation. These include the recovery in oil prices from multi-year lows in February, rising US inflation (we note that the US minimum wage is expected to be raised significantly), and the deflationary effects of China’s slowdown mitigating amid the stabilisation of its economy. The anticipated adverse effect of the UK’s EU secession has also led the UK Government to suggest that it will increase fiscal spending to support the economy, adding to domestic demand-pull inflationary pressures.
Under normal circumstances, the BoE’s remit is to try and maintain UK inflation at 2%. However, its November inflation report showed that it will look through transitory factors, such as the effect of oil prices and sterling’s decline, and tolerate a higher level of inflation in the medium term in order to support economic activity. Given this, we judge it likely that the UK is entering a period where inflation will be above the BoE’s 2% target.
Economic and investment implications
A rise in inflation will have positive effects, such as reducing real debt levels (debt is measured in nominal terms). However, investors will have to protect their wealth by investing in assets that can generate returns above the level of inflation, which presents a problem in the current environment where central bank policies have depressed yields. There are still ways in which investors can mitigate the negative effects of inflation; one of these is to identify and invest in the equity or bonds of companies with pricing power. With this in mind, we have recently held a focus on the infrastructure sector: this is an area where many companies operate natural monopolies, providing services for which demand is highly inelastic and whereby price is contractually linked to the level of inflation.
Although we would advocate investors preparing to protect their wealth against rising prices under the current circumstances, we note that in the current volatile political environment further dramatic foreign exchange movements could occur that would quickly change the investment environment.
The above article was first published by Brookes MacDonald on 9th November 2016.