Investing for Higher UK Inflation: Should You Be Rebalancing Your Portfolio?

Earlier this week data from the Office for National Statistics showed that in September the UK’s year-on-year rate of inflation had reached 3%. Headlines dramatically announced the fact that this is the fastest uptick in the cost of living we’ve seen in the past 5 years. Bank of England Governor Mark Carney has forecast that inflation will still see a further rise, to ‘peak’ in the next couple of months.

3% inflation is above the UK’s 2% target rate and slightly higher than the average 2.58% rate since 1989. However, while not ideal, 3% inflation is also not a hugely worrying level despite the fact the next couple of months are forecast to see further increases before Carney’s ‘peak’ level is reached. The main worry when inflation starts to creep beyond 3% is that it has a bad habit of gathering momentum. The Bank of England doesn’t appear concerned for the moment though and it would seem expectations are for another couple of months of moderate inflation growth before a reversal back towards target levels.

Inflation, a measure of how fast the prices of goods and services are rising, is measured monthly against the CPI (consumer price index). This tracks 180,000 price quotations provided by a range of retailers for 700 different goods and services commonly bought by households. The ‘basket’ of goods and services that form the CPI is updated quarterly to reflect changes in preferences over time.

There are several factors that can influence inflation rates, and the prices of the goods and services the CPI is made up of. An increase in money supply resulting from quantitative easing (QE), which is money printing by the central bank, is one. That’s not thought to be the cause at the moment, despite the fact the Bank of England, Federal Reserve, European Central Bank and other major central banks around the world have been indulging in plenty of QE since the financial crisis. Despite significant QE around the world, global inflation has been very low in recent years. Some analysts believe that the levels of global QE over the past decade, which haven’t been obviously reflected in inflation so far, will come back to bite us. However, whether that turns out to be the case or not, it’s not being posited as the reason for the recent increases in the UK’s inflation rate.

The other major driver of inflation is increasing demand for goods and services. This usually happens when an economy is heating up. Increased economic activity leads for competition for goods and services that have limited supply, pushing up the prices as buyers compete. However, with economic growth subdued since the Brexit vote, despite so far holding up better than expected, that also doesn’t seem to be the cause.

In the opinion of Carney, the ‘sole reason’ for recent inflation growth is the drop in the value of pound sterling. A weaker pound has meant that any imports British companies buy denominated in other currencies, such as the euro or dollar, cost more in sterling. Carney’s explanation is borne out by the fact that the most significant drivers of current inflation are prices in the food, transport and recreation categories. Recreation is not quite so clearly linked to import prices but much of our food stuffs in the UK are imported from the EU and further afield. Transport costs, of which air fares showed the most significant growth, are also highly dependent on the price of oil. Oil prices have been rising since the summer and are also denominated in dollars.

Basically, Carney’s explanation stacks up. If, and there is currently considered to be a 50% chance of it happening, the BoE makes the call to increase interest rates slightly for the first time in a decade, to 0.5% from their 0.25%, the chances are pound sterling will strengthen. If the weakened value of sterling is indeed the ‘sole reason’ for the current uptick in inflation, we should then expect it to drop back towards the target 2% level again. 

At present, investors won’t be rushing to make major inflation-hedging adjustments to their portfolios, or at least not major ones. However, some may well be starting to gradually increase an inflation-friendly hedge and be keeping a close eye on inflation over the coming months. As far back as last year major fund managers were starting to move away from sectors and asset classes that benefit from low inflation, such as bonds, property and ‘non-cyclicals’. So, how does higher inflation impact on investments and what are some ideas for inflation friendly assets to consider if the inflation rate defies Carney’s prediction and doesn’t ‘peak’ within the next few months?

Broadly speaking, equities have historically tended to have a positive correlation with inflation because companies pass rising costs on to customers. There are, however, particular sectors that benefit most and are worth looking at.

Finance: banks and companies in the wider financial sector such as money managers are worth looking at. If the Bank of England increases the base interest rate to help cool inflation, banks will benefit as lending becomes more profitable for them and variable existing loans out will rise in value on their balance sheet.

Telecoms: James Sym, Fund Manager for European Equities at Schroders, tips the telecoms sector as one to look at if higher inflation levels stay in place. His argument is that if inflation makes a comeback, we’ll all be paying a little more for our phone and internet bills despite the fact costs for telcos are largely fixed:

“it’s the cables in the ground, the mobile towers. Those costs will remain unchanged but their revenues, and profits, should look much more sustainable as inflation allows higher prices.”

Water and waste utilities: the same logic applies here as to telcos. While energy utilities have variable costs that fluctuate with the price of fossil fuels, with the exception of renewables (also work a look though most listed companies focused on renewables are small and so riskier), water and waste utilities don’t so rising prices should mean rising profits for them. However, water and waste utilities can also be highly leveraged so increasing interest rates will impact them and investors should pay particular attention to this.

UK-focused equities: many of the larger companies listed on the London Stock Exchange, particularly those of the FTSE 100, generate much of their revenues abroad. As such, higher inflation in the UK wouldn’t have a strong impact on these companies. On the contrary, if interest rates are raised to control inflation and pound sterling strengthens, this would have a negative impact the inverse on how the weakened pound has helped boost their share prices over the past year and a bit.

Shifting portfolio exposure more towards domestically-facing companies that will benefit from a strengthened pound and higher prices in the UK would make sense.