UK inflation insights

This morning’s Consumer Price Index (CPI) announcement revealed that UK inflation dipped last month, despite still being well above the Bank of England’s two percent target.

September’s figure was 3.1 percent, down slightly from 3.2 percent in August (the highest in over nine years).¹ Analysts had forecast that inflation was likely to remain at 3.2 percent for the month.

Mike Hardie (Office for National Statistics (ONS) Head of Prices) commented that the small dip was caused by the ‘unwinding effect of last year’s “Eat Out to Help Out”, which was a factor in pushing up the rate in August’.² As illustrated below, increases in most sectors last month were offset by a large decrease in restaurant and hotel prices.

Last month, the Bank of England advised that inflation could rise to more than four percent this year, and economists have warned that September’s small decrease is likely to be temporary.

Governor Andrew Bailey’s comments at the weekend certainly sounded more hawkish than his ‘Hard Yards’ speech of 27 September. While he maintains that price pressures will be short-term in nature, he added that the surge in energy prices would drive inflation higher and make it last longer.

Against this backdrop, we spoke to Neville Pike (UK Equities Product Director) and Georgina Taylor (Multi Asset Fund Manager), who shared their views on UK inflation, and how their teams have positioned their portfolios. 

Neville, what do you make of the current situation?

NP: Markets had got used to the idea that inflation was a thing of the past, but it is increasingly clear that we are now in an inflationary environment. What was first manifest in rising commodity prices has since spread to the supply chain, to wage inflation, and the word transitory is being used less and less.

What’s next? What policy response do you expect to see?

NP: We do not make forecasts of interest rates, but we would expect the Bank of England’s Monetary Policy Committee (MPC) to proceed with caution as they are unlikely to want to lean against the economy too hard and may be willing to tolerate a period of higher inflation as a result. After a period of time when central borrowing has ballooned, inflating the nominal economy may also be viewed in government circles as desirable.

In such an environment, it is worth remembering that equities in general are a hedge on inflation. 

What does this environment mean for the team’s portfolios?  

NP: A number of our funds have good exposure to utilities, which often have explicit index-linking in their business models. Higher inflation also tends to result in a higher cost of capital and more plentiful nominal growth. Both of these factors would put pressure on high value stocks and favour short duration or value investments. These have long been the focus of the Invesco UK Opportunities Fund (UK). 

In the Invesco UK Equity Income Fund (UK) and the Invesco UK Equity High Income Fund (UK), we have consistently tried to identify businesses with more control over their cost bases. Likewise, we have sought companies that operate in a niche, do something special, or have contractual terms that confer pricing power. Given that these are the key characteristics we aim to invest in, the portfolios look relatively well positioned for this environment.

Are there any particular positions you would like to highlight? 

NP: The Invesco UK Opportunities Fund (UK), the Invesco UK Equity Income Fund (UK) and the Invesco UK Equity High Income Fund (UK) each have exposure to land/housing and to gold mining equities. This should also act as a good hedge against inflation and currency debasement.

The equity market seems to assume that whatever rate of inflation we are faced with will be offset by a commensurate rise in interest rates/yields. Our view is that rate setters will remain deliberately behind the curve and prepared to act to contain market rates of interest. If that’s correct it should be a particularly positive environment for gold.

Georgina, as a multi asset investor, how do you approach inflation?

GT: Given that we run a very diversified portfolio of investment ideas across and within asset classes, inflation has undoubtedly been an important area of focus for our team. As long-term multi asset investors, we can lean into the inflation theme directly or find investment ideas which are less impacted by the high level of volatility around inflation expectations.

What do you make of the current environment?

GT: Underlying inflation readings globally have been rising significantly, and the market’s pricing of future inflation has been rising with it. While we don’t expect markets to collapse, a change in investment environment may mean we see a change of leadership within the equity market.

How are your portfolios positioned at present?

GT: Focusing on companies that benefit from strong pricing power and sectors that tend to exhibit a positive correlation to higher inflation and higher bond yields, for example, banks and energy, has been an important theme that we have expressed in our portfolios in recent quarters.  

At the same time, the team continues to leverage its unconstrained investment approach to try to exploit market mispricing within this asset class. Uncertainty over the ultimate persistence of inflationary pressures has driven some extreme moves in market expectations, with the UK inflation market being a prime example of such an anomaly.

Market pricing of UK inflation relative to underlying economic activity looks too elevated longer-term, in our view, despite the strong recovery post pandemic. After the initial bounce, the macro disruption caused by Brexit and Covid-19, should ultimately be disinflationary. We therefore remain short the UK inflation market via inflation swaps.