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What Does the Highest Inflation Rate in 5 Years Mean for Investors?

Highest Inflation Rate

You’re probably aware that the UK’s rate of inflation has hit 3% and that this is its highest level in 5 years. The story’s been leading the news this week and generating the headlines over printed and digital media. The focus, as usual, has been on Brexit and how the fall in the value of the pound since the referendum has led to a rise in the cost of anything imported into the UK – which is a lot of things. Standard Brexit hysteria covered, the second most discussed element to the inflation rate has been the fact that wage growth has lagged inflation so we are, on average, all 0.4% worse off than a year ago.

Sensationalist headlines aside, and by no means denying that Brexit uncertainty is a danger to the UK economy, inflation running at 3% is not, in itself, particularly worrying, particularly as the largest influence was the, presumed, on-off influence of a significant drop in the value of the pound. The Bank of England’s target inflation rate is 2%. The governor of the Bank of England is far more likely to get a nervous phone call from Number 10 if inflation falls below 2% than a little over it. Between 1989 and 2017 the average UK inflation rate has been 2.58%. In April 2015, inflation hit its lowest recorded level at -0.1%. That was far more significant than September’s expected 3%. In 1991 we had an inflation rate that reached 8.5%.

The long and short of it is that while 3% inflation is a little higher than ideal and edging towards danger territory, it isn’t anything to get into any great flap about, particularly in the context that it’s largely connected to exchange rates. The main danger is that inflation rates have a habit of gathering steam so the BoE will want to make sure inflation doesn’t start heading towards the 4% level or higher.

Which is why the central bank might well start to raise interest rates again in the near future. It isn’t 100% sure, with voices of opposition from within the committee who think raising the cost of borrowing will do more harm than the good of dampening inflation, but it’s likely. There is a reasonably high chance the benchmark interest rate will be raised to 0.5% before the end of the year, with the next BoE meeting in November, and some analysts believe it could potentially go as high as 3% in the foreseeable future.

What an environment of higher inflation means for investors was the question posed in the title. Apart from the fact that it increases the incentive for assets not to be held in cash, with the combination of 3% inflation and rock bottom interest rates eroding value, the biggest impact will come from inflation provoking a rates rise. Many investors will have positioned investment portfolios specifically for the current low interest rates environment. Rises may mean a rebalance makes sense.

Bonds: with interest rates rock bottom since the financial crisis, bonds have increased in popularity with the 1% rate paid on government gilts looking more attractive than usual. A rise in interest rates could see investors locked into more negative returns. Investors with heavier bond weightings might want to start reducing their holdings. On the other hand, a stampede to sell bonds will push prices down and could provide a good buying opportunity for others.

Equities: the Bank of England initiating the first rise in interest rates in a decade would be expected to considerably strengthen the pound. This could well have a negative impact on UK-listed equities, particularly the internationally-facing FTSE 100, whose companies generate 70% of revenues abroad. The London Stock Exchange has risen considerably since the Brexit vote and the weakened pound has been given much of the credit for that so a strengthening pound would be expected to hit equities.

Anthony Gillham, the head of multi-asset funds at Old Mutual was quoted by The Telegraph as saying that “Moving into smaller and medium-sized companies, which are more domestically focused, might be a better option,” in the case of any significant strengthening in the value of the pound.

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Paul

The author Paul