Is the inflation genie out of the bottle?

Posted by Liz Rees in Latest insights category on 28 Feb 20


What is driving inflation in the UK?

The main contributor to an increase in the rate of inflation were housing and utility bills along with clothing and airfares.  

The Bank of England expects inflation to continue to rise, but has a fairly broad forecast stating that it expects the 2% target to be reached within 3 years as business confidence returns. Wage growth and record employment may also push inflation higher. 

Friend or foe?

Modest inflation is usually a good thing. It reduces the value of outstanding debt such as mortgages or bank loans, and helps encourage spending as it means that prices will be higher in the future.

Too much inflation, on the other hand may indicate an overheating economy and prompt the Bank of England to raise interest rates. However, current weak economic data suggests this is unlikely.

Furthermore, inflation is not good news for savers. Having already suffered a decade of record low interest rates, inflation is damaging the returns they get. Those who hold cash in accounts paying interest at well below the rate of inflation risk losing money in real terms.

The chart below shows how the returns on a typical instant access savings account have lagged behind the Consumer Prices Index over the last decade.

Cash v CPI

Premium Bonds are the latest cash product to see their pay-outs slashed. Whilst savers stand the chance of winning large sums on their premium bonds the overall interest paid out in prizes will fall from 1.4% to 1.3% in May this year.

Outlook

Inflation remains modest relative to history and we do not see it as one of the main risks facing the economy at present. However, the latest CPI figure may have deterred the Bank of England from cutting interest rates in February.

A rise in the minimum wage this year, along with new immigration controls in early 2021, could be inflationary and might put pressure on production and operating costs.

Which investments protect against inflation?

Gold has a history of protecting against inflation, however it does not pay any income unless exposure is via riskier gold mining companies.

Real assets such infrastructure, may offer protection as the revenues from long-term projects are often linked to inflation. We reviewed prospects for this sector in our recent email on HS2.

Bond investors may turn to index-linked gilts, although yields on such funds are modest. Another option is UK Equity Income funds, many of which currently yield over 4.5%. The advantage of investing in shares is the potential, though not a guarantee, to increase dividends over time. However, in the short term share prices can be volatile as we have seen this week with the corona virus fears hitting markets.

Morningstar bronze-rated Man GLG Income Fund focuses on companies with strong cash generation and cash reserves. Manager Henry Dixon believes these qualities give the best chance of dividend surprises. The yield is currently 5.4%.

Richard Colwell’s silver-rated Threadneedle UK Equity Income Fund blends high quality large cap companies with recovery situations to produce a steady income. Currently the yield is 4.1%.

Using an ISA wrapper will ensure any growth or income is free of tax.