Posted on: 26 October 2016
Elected leaders, politicians from all sides, skilled negotiators, lobbyists, the media and, of course, lawyers…
The challenge of steering the UK through the choppy waters ahead lie with many whose approach to charting a course differs hugely, but with a common objective of protecting the country’s economy and interests. Navigating through the politics of negotiating Brexit with the other 27 EU countries, and the type of relationship the UK would have with the EU from the outside, is certainly daunting.
Inflation – the rising tide
The Office for National Statistics announced that inflation, as measured by the Consumer Prices Index (CPI), rose to 1% in September, compared with a 0.6% rise in the year to August. It was the highest inflation rate since November 2014, when it was also 1.0%. At this point, the rate had begun to fall, remaining at or around zero for much of 2015 before gradually picking up from the end of the year. The main upward contributors to change in the new rate announced were rising prices for clothing, overnight hotel stays and motor fuels, and prices for gas, which were unchanged, having fallen a year ago. These upward pressures were partially offset by a fall in air fares and food prices.
The CPI inflation measure is also used by the Government for purposes such as uprating pensions, wages and benefits and can aid in the understanding of inflation on family budgets, calculating student loans and deciding interest rates.
Inflation is forecast to rise further as the 15% sharp drop in sterling since the EU referendum in June is expected to push up prices. The Institute for Fiscal Studies commented that: “This observation focuses on one consequence that higher inflation would have: the fact that it would reduce the real incomes of working age families receiving benefits that the Government has frozen in cash terms through to March 2020”.
Speaking during a recent tour of the Midlands, Mark Carney, the Governor of the Bank of England, said, “We’re willing to tolerate a bit of overshoot in inflation over the course of the next few years, in order to avoid rising unemployment, to cushion the blow and make sure the economy can adjust as well as possible”. Adding that the situation was going to get difficult for those on the lowest incomes as we move from no inflation to some inflation.*
The last time sterling fell so dramatically the UK was in the midst of the global financial crisis from 2007 to 2008. The currency shock sent inflation shooting up to 5.2%, putting significant pressure on real living standards.
In its April ‘World Economic Outlook’, the International Monetary Fund (IMF) forecast CPI inflation to rise to 1.9% in 2017 before settling at 2.0% from 2018. By its October forecast the IMF had revised its inflation expectations to 2.5% in 2017 followed by 2.6% in 2018. Those forecasts were based on the exchange rate as it stood in mid-September; since then the pound has fallen a further 7% against the dollar and so, if anything, these numbers may in fact underestimate future price rises.
The real cost of maintaining living standards
Consumer demand and producer supply – simple economics. The consequences though of the current falling pound are making the cost of the goods imported into the UK more expensive. There are already the first signs of rising food prices; energy prices will most likely be the next price to rise, so higher heating and petrol bills. Even some goods that are deemed to be made in the UK will be subject to currency pressure as they contain imported parts and will certainly incur distribution costs.
There are some industries which are benefitting from a weak sterling. Tourism and manufacturing exports have been boosted, while there has been something of a surge in overseas investment in UK property.
With the rise in prices the need to protect the real purchasing power of ‘the pound in your pocket’ is fundamental to longer term investment choices.
Positioning and opportunities
Views around the impact of inflation on investment portfolios vary widely, while the measures taken to protect against the impact of inflation can also differ depending on a client’s objective. Simplistically we might think that holding index-linked bonds might be an effective tool, but these are currently very expensive relative to their history and so may not provide the level of protection from rising inflation that investors might expect.
Over longer periods of time, equities have been shown to protect savings from the deleterious impact of inflation because companies can largely pass on cost increases to their own customers. However, this has to be balanced against a client’s willingness and ability to take equity risk within their portfolio. Other asset classes, such as commercial property and infrastructure may have inflation-linked characteristics, though as with every investment we consider, the valuation at which these assets are available can impact the levels of protection they eventually provide.
In summary, there are various ways in which an investment portfolio can insulate against inflation, though many take some time to filter through into results.
 Index-linked bond is a bond in which payment of income on the principal is related to a specific price index, often the CPI.
All data has been compiled by Duncan Lawrie from sources believed to be reliable. Full details of sources are available on request.
The comments and figures in this document are generally applicable but you should always take specific advice to suit your individual circumstances before taking any action. Errors and omissions excepted.
The value of investments and income generated may fall as well as rise, and investors may not get back the amount invested. Past performance is not a reliable indicator of future results.