Investors should beware the ongoing fall in inflation but not panic and materially alter their portfolios – especially as the trend may signal lower interest rates that are likely to bolster equity markets, according to a number of fund managers, strategists and analysts.
UK inflation, as measured by the consumer prices index (CPI), is now at a 25-year low having fallen to 0.3 per cent after moving down from 0.5 per cent last month. This follows a recent warning from Bank of England governor Mark Carney that UK inflation could enter negative territory in the coming months.
Ben Willis, head of research at Whitechurch Securities, says he will not make any material changes to his portfolios because of the move but is mindful that the trend toward low or negative inflation could herald nastier consequences in time.
“Inflation has been coming down because of the low oil price and the supermarket price war. It is not a surprise and has been signposted,” he said.
Oil is still more than 45 per cent lower than its June 2014 high but has recently had a cautious uplift.
Performance of index over 1yr
Source: FE Analytics
Willis said: “You could argue that bonds work best in a deflationary environment. But considering what has been going on in the background and where the market has become artificially manoeuvred by the central banks, bonds look unattractive because of their yields."
“Inflation has been relatively low for some time but we are still not moved to buy more bonds.”
“[Falling inflation] will affect certain areas, particular in domestic consumer companies, so you need to be selective and there will be certain areas where deflation is going to have an impact – so we are looking at managers who will identify that.”
“It is definitely something to keep an eye on, because what affects the economy will eventually filter through. If consumers start to think that they should hold off buying things because they are going to get cheaper, that is going to put pressure on the economy.”
Willis says this is the worst case scenario, however, and investors should be able to navigate away from the potential downside.
“It is more domestically-focused UK companies that will come under greater pressure, particularly those that are focused toward the consumer, because they won’t have the international revenues of other firms to take the pressure off.”
Maike Currie, associate investment director at Fidelity Worldwide Investment, says the deflationary pressures now in the UK and across the globe are raising the prospect of looser monetary policy for longer.
“Investors need to distinguish between disinflation – a slowdown in the rate of inflation – and deflation – a persistent and ongoing fall in prices – [as] the two are not the same thing. It is worth remembering that both food and fuel – the main drivers of the fall in inflation – are two essential items,” she said.
“No-one is going to delay their weekly trip to the supermarket or stop filling up their car’s petrol tank because they expect prices may fall next month.”
However, Currie says for investors worried about the trend, there are ways to mitigate a continuing fall in inflation.
“If you believe the current rate of inflation in the UK is uncomfortably close to deflation and want to shield your portfolio against this threat, look for companies with strong brands which benefit from pricing power. Companies that have a unique product and strong brand will be in a better position to increase prices regardless of the broader economy,” she said.
“A number of the UK fund managers adopt an investment process which focuses on industry leading, quality companies that have been around for generations and are likely to be around for a long time to come.”
Currie says investors may wish to turn to FE Alpha Managers Nick Train, who heads up the £1.4bn CF Lindsell Train UK Equity fund, or David Dudding of the £2.2bn Threadneedle European Select fund.
Both managers tend to favour mega caps specialising in consumer products and having a global customer base. This approach has helped the pair to score some of the lowest volatility and drawdown scores in their respective sectors.
Train is up 177.71 per cent over 10 years, beating both sector and index by more than 100 percentage points. Dudding has returned 104.42 per cent since taking over his fund in July 2008, more than doubling the gain of the benchmark and sector.
Performance of fund, sector and index over 10yrs
Source: FE Analytics
David Madden, market analyst at IG, says the anticipated drop in UK CPI has planted the seed in traders’ minds that the UK will follow the eurozone down the route of deflation.
Despite this, the FTSE 100 up five points to 6,860 in mid-morning trading but Madden says the fall could have a wider impact on markets if it delays an interest rate rise or even prompts a further cut.
“Mark Carney recently stated he would cut interest rates from their historic low if necessary and now that UK inflation is at a record low he may be forced to fulfil his promise,” he said.
“Mr Carney won’t be in any rush to loosen the monetary policy, but the falling cost of living is an artificial wage boost for the British consumer, which at least will help the economy where retail sales are concerned.”
Chris Iggo, chief investment officer for fixed income at AXA Investment Managers, notes that Carney recently said the Bank would consider cutting interest rates and re-starting QE if UK inflation was persistently below target.
“This ‘deflation hedging’ bias from central banks is likely to persist, at least in the short term, as annual inflation rates will fall further into the spring. This mostly reflects the fall in oil prices. The year-on-year decline in oil prices will not turn around for some months and this will mean continued downward pressure on consumer price inflation rates,” he said.
“It will be difficult to tighten monetary policy when inflation is well below target so the pricing of monetary tightening will depend on the ability of central bankers to persuade markets to look through the oil price effect – which is transitory – and to think about what will happen to inflation in response to reduced spare capacity.”
Iggo says this is only categorically relevant to the US and the UK in the foreseeable future with the behaviour of wages and core inflation very important throughout 2015.
“A nasty bond market sell-off would surely take place if suddenly headline inflation jumped higher as the negative effect from oil prices fell out of the annual rates. The Fed will be careful, having taken such a long time to get to the ‘take-off’ point, not to be seen to have fallen behind the curve.”
Stephanie Flanders, chief market strategist at JP Morgan Asset Management, says investors shouldn’t be overly anxious about the prospect of UK deflation.
“Certainly market expectations for a UK rate rise have moved a long way back in response to falling inflation expectations and declining long duration rates everywhere, but expect to see Carney and the Monetary Policy Committee also note the consumption boost the UK is receiving from lower oil and energy prices. Strong economic and spending growth may act as a counterbalance to falling inflation,” Flanders said.