Is the UK’s bout of inflation a temporary condition or something more serious? Either way, investors and wealth managers should ready themselves for challenging times to come.
UK inflation is expected to hit 5% next spring. The Bank of England thinks it will then begin to fall, coming close to the target of 2% in two years’ time. Even so, the annualised rate of inflation for 2022 will likely be higher than it’s been for more than 30 years – since Black Wednesday, when the country was forced from the European Exchange Rate Mechanism.
Inflation can be catastrophic, so it’s welcome news that independent economists seem to agree that the Bank is approximately right. This isn’t a permanent shift, they say, though risks remain.
“In the sense that the forces that are initially causing the inflation are temporary, I think that’s a fair point,” says Rory MacQueen, principal economist at the National Institute of Economic and Social Research. The institute forecasts consumer prices index (CPI) inflation of 4.4% next year and 3.4% in 2023 before getting back below target in 2024, conditional on base rate rises in 2022 and 2023. It forecasts annualised GDP economic growth of 4.7% in 2022.
Over at Capital Economics, chief UK economist Paul Dales agrees that inflation is a temporary concern. Interest rates will top out at about 0.5% at the end of next year, he thinks, while “fairly soft” economic activity will help inflation drop to around 2% at the end of 2022. “Moderately higher interest rates are unlikely to derail the economic recovery,” says Dales.
So far so good. However, MacQueen points to a wage-price spiral as cause for concern.
“If we see everyone pricing expectations of inflation into their future plans, theoretically it could be a self-fulfilling inflation, in which temporary factors lead to permanently higher inflation.” However, this isn’t his think tank’s central scenario, he notes. “We think the bank will take enough action to bring it towards target, though perhaps not as quickly as some would like.”
Behind the curve?
Not everyone is so sanguine. Ruth Lea is an economist and economic adviser at Arbuthnot Banking Group. She is critical of the Bank of England’s failure to raise rates in November and worries they may have fallen behind the curve. “They have to start signalling that they’re going to hold back on some of the wilder excesses of demand in order to get to grips with what could become embedded inflation,” she cautions. “If inflationary expectations do get embedded then he [Governor Andrew Bailey] might have to put [rates] up by more, and in the meantime, don’t forget fiscal policy is still pretty generous.”
But how much freedom does the Bank really have? Russ Mould, investment director at AJ Bell, says it’s behaving as though it has “more of a [US] Federal Reserve dual mandate”, where unemployment is a joint priority along with inflation. “I suspect that the Bank of England is also aware that the debt position in the UK is a lot higher than it was 18 months ago, so the economy is relatively more sensitive to minor changes in interest rates,” adds Mould.
What are investors and wealth managers to do? Mould is clear. “There is no alternative if you assume that central banks will keep real rates negative for the time being. If you’re getting a negative real return on bonds, a negative real return on cash … there is no alternative and you’re left looking at equities.”
There is a sense that real assets will do better than paper assets in a genuinely inflationary episode
Mould favours stocks that command pricing power over those that can be pushed about by competitors and customers. “You need companies with pricing power because otherwise your margins will get crushed,” he says. This is a contrast from the last decade, where investors have ploughed into tech and growth stocks promising profits in the future.
“They’re the very companies that you just do not want to own in an inflationary environment because their costs go up and they’re involved in a competitive dog fight for market share,” Mould warns.
Time to get cyclical
Instead, investors should back value stocks and cyclicals like banks, airlines and car makers, says Mould. He reckons we could see “a degree of violence within the stock markets and market leadership changing”. And then there’s gold, which did well in the 1970s inflation, although he notes that it started from $35 an ounce back then, rather than the $1,800 level seen today.
“There is also a sense that real assets will do better than paper assets in a genuinely inflationary episode because central banks can print money but they can’t print gold, oil and property,” he says, adding that some investors will find a place for cryptocurrencies as a hedge.
Mould’s advice is echoed by Robert Sears, chief investment officer of private wealth manager CapGen, which has £3bn in assets under management. “There is no one pure hedge for inflation,” says Sears, who has been building CapGen’s hedging positions. “You want a number of different assets which do well in different types of inflation.”
In a low-growth inflationary environment he recommends inflation-linked bonds, but if real rates go up he backs commodities, liquid exposure to commodity futures and gold. For an environment “somewhere in between, where inflation is high but you’ve still got relatively decent growth”, he looks to real estate, equities with pricing power and value stocks.
Sears is particularly keen on inflation swaps today, mainly because they fit with his assessment of the inflationary cycle. “The focus at the moment is what’s inflation this year, next year … but what’s really interesting is the markets expect inflation to come back pretty quickly in line with the experience of the last 30 years.”
However, he disagrees with this assessment, seeing a lot of potential inflation risk in the medium term, partly because of lasting changes from Covid, such as onshoring. Against this view, inflation swaps for the medium-term outlook appear under-priced in the market, he believes. “It’s not much downside, and yet if inflation was like the 1970s, you’d make a lot of money,” says Sears. As ever, challenges offer opportunities.
