Prospects for UK Inflation

The prospects for UK inflation has divided investors but I have held the view for several years now that inflation will surprise on the upside. Opponents point to the muted effect on inflation from QE and slow economic recovery from the worst global financial crisis and recession in living memory. Governments, companies and individuals have been paying off debt and storing cash rather than spending. So it was with interest that I read an article on UK inflation from Ben Lord, co-manager of the M&G UK Inflation Linked Corporate Bond fund. Some of my clients hold this investment and other inflation linked funds. The main points of this article can be summarised under the following headings:

Five years of sticky cost-push inflation

 Uniquely the UK inflation rate in the last five years has been “sticky” despite the very deep recession. It has been above the Bank of England’s CPI (Consumer Prices Index) inflation target of 2%, in conditions where deflation might have been expected. The cause of inflation has been household cost increases in energy and food. Moreover the National Audit Office recently predicted consumers face 17 years of above inflation price increases for gas, electricity and water to fund new infrastructure. To this we could add rising rail fares and rents.

Another contributor has been Sterling weakness, which makes imports more expensive. According to M&G Sterling has lost around 20% against the Euro and US Dollar since 2007. This effect on inflation has been exacerbated by the UK’s current account deficit. This means we import more than we export.

Time for demand-pull inflation?

M&G argue weak consumer demand, notably discretionary spending has kept inflation down in recent years. However Ben Lord believes we could face a demand shock to add to the cost pressures from essentials such as energy and food. This would come from the recent UK economic revival which has been stronger than anticipated whilst growth has been in manufacturing and construction not just services. The rally in UK house prices will further increase consumer confidence and hence encourage spending.

Central Bank Policy

The unprecedented printing of cash by central banks since 2007 is described by Ben Lord as an experiment where no-one truly understands the consequences. The expectation of higher inflation from Quantitative Easing (QE) has not materialised as banks have been hoarding the money they have received rather than lending it to businesses. An increase in bank lending could be inflationary.

Another key point is that the Bank of England is primarily concerned with securing growth in the economy rather than controlling inflation. In fact inflation might be viewed as a relatively painless way to reduce public debt and Lord thinks interest rates will stay low for some time.

Conclusion

Lord concludes the gilt market continues to underestimate future inflationary pressures by under valuing index linked bonds. The difference in yields between index linked gilts and comparable fixed interest bonds is used to determine what the market is pricing a breakeven inflation rate, as measured by RPI (Retail Prices Index) to be. This market rate is just 2.9% over the next five years whereas RPI has averaged 3.7% over the last three. Index linked bonds pay a real return in excess of RPI rather than CPI. The former includes housing costs such as mortgage interest. Normally RPI exceeds CPI and Lord thinks the gap will increase.

To finish Ben Lord reckons index linked bonds which provides a hedge against inflation provides cheap protection at this point in time. Inflationary expectations can increase rapidly and such protection could be considerably more expensive in the future if the market re-rates index linked gilts.

I conclude there is a case for investors to add inflation linked investments to portfolios especially where there is none. If inflation rises and the RPI increases at a faster rate than CPI, index linked gilts and corporate bonds should rally. Conversely inflation will be negative for fixed rate bonds and index linked holdings will provide a hedge against capital losses.

This blog is intended to be a general investment commentary only. You should seek individual financial advice before making investment decisions.