After years of a disinflationary environment, the latest UK inflation figures surprised both the Bank of England and investors by coming in higher than expected.
Earlier this year the Bank of England predicted inflation would fall to nearly zero in 2020 due to the economic impact of the coronavirus pandemic.
Covid-19 triggered a supply and demand shock along with record breaking amounts of monetary and fiscal stimulus, with the ultra-loose monetary policy of all-time low interest rates and a fresh quantitative easing programme being combined with massive amounts of government spending to shore up the economy.
While economists had thought this would have little effect on inflation, which has been stubbornly subdued for some time, the latest data from the Office for National Statistics (ONS) shows the consumer prices index (CPI) jumped from 0.6 per cent in June to 1 per cent in July.
Source: ONS
The unexpected increase was attributed to rising oil prices following a slump earlier in the year and the fact that many UK non-essential businesses were able to re-open in July after months of lockdown, leading to an increase in spending again.
CPI inflation remains below the Bank of England’s 2 per cent target but the jump has left some asking whether investors need to start preparing their portfolios for the return of inflation.
Simon Evan-Cook, senior multi-asset manager at Premier Miton Investors, said a lot of investors were positioned for another drop in inflation, as this has been the dominant trend of recent years and has contributed to the outperformance of growth stocks, which tend to do well in a low-growth environment.
“We believe that many more investors may be unknowingly betting on the death of inflation through their choice of assets,” the manager said.
“This is because any asset that has done well over the last 10 years – and particularly the last two – is most likely an asset that benefits from deflation. And we can see from the sales figures that people are piling into assets or funds that have performed well, while selling those that have done badly. Performance chasing, in other words.”
Following the 2008 global financial crisis, markets appeared to be in a persistently disinflationary environment, one which has supported growth stocks. And growth has continued to be a “winning strategy this year”, Evan-Cook said, as the lockdown was highly deflationary.
But Covid-19 has created a turning point in deflation’s path. Evan-Cook has been preparing his balanced portfolios for both continuing deflation and the return of inflation, “as both are possible paths that we could collectively take”.
“Should inflation return, either through a natural uptick in economic activity, or as a result of the large increase in fiscal spending, then the previous deflationary winners are likely fare relatively poorly, while assets that were previously under the cosh may begin to win again,” he said.
“This would be very bad for those who only have their investment portfolios exposed to the deflationary winners.”
This idea of market complacency around inflation is present, according to Richard Staveley, portfolio manager at Gresham House.
Along with Evan-Cook, Staveley agreed that the latest ONS stats took most of the market by surprise, although he added that the near-term effects of Covid-19 were likely to be deflationary because of the destruction to demand and debt write-offs.
But Staveley said that there are a few reasons why it looks like inflation could rise over the coming years.
“We believe there is considerable complacency surrounding consensus belief in central banks’ effectiveness,” he said.
“The size of central bank intervention during this crisis materially exceeds prior QE programmes and thus may not be well calibrated this time round. If too large, inflation should pick up.”
“De-globalisation, minimum wage legislation, the pricing power of ‘survivors’ and M2 growth all contribute to the risk that the benign consensus inflation is permanently beaten will be challenged in the years ahead.”
Added to this, Staveley said there is social pressure for the UK government to avoid using austerity to relieve the UK’s £2trn debt, suggesting that there is a strong change that rising inflation will be allowed “to take the strain of the massive debt in the system.”
Tony Yarrow, manager of the TB Wise Multi-Asset Income fund, agreed with this point, adding: “Central banks and governments have ceased to be worried about inflation and are these days are more interested in stimulating than controlling it, and investors all assume that inflation is dead. The guardians of inflation are all asleep.”
Another element to this potentially inflationary period is the value versus growth debate.
As stated above, the growth style of investing has flourished in the previous deflationary environment, with the gap between value and growth stocks now miles apart.
Performance of value versus growth over 10yrs
Source: FE Analytics
This has been exacerbated by the coronavirus crisis as growth companies, such as tech, have rallied whereas value areas such as oil & gas and struggled with falling demand.
But this shift in inflation, combined with the early recovery the UK economy is now in as it emerges from recession, could be the catalyst markets have been waiting for to knock growth off its rally.
Staveley very much supports the idea that value will overtake growth at some point.
“For literally decades ‘value’ stocks consistently beat ‘growth’ stocks. So much so that despite value’s terrible recent performance, the longer-term data still indicates ‘value’ beats ‘growth’,” he argued.
But while many investors may now be considering diversifying their growth-oriented portfolios with some value holdings, BlackRock’s Dan Whitestone heeds some warning to investors not to confuse cheap with value.
“We often find that shares that are flagged as cheap or value have, on closer inspection, poor cash conversion,” Whitestone said.
“Today there remain many companies that we believe are masquerading as ‘cheap value’ just because they trade on a low price to ‘adjusted earnings’.”
Whitestone said investors should not be “seduced by merely low P/E, a high dividend yield, or a recently weak share price” and shouldn’t let a rising share price or high P/E discourage them. Rather they should focus on understanding all the characteristics of a company “that can result in long-term compounding success”.
“We think this approach has shown real success and we would never pick shares just because they ticked some statistical growth criteria,” he added.