The Consumer Price Index has reached its highest level in two and-a-half years at 1.8 per cent for January, bringing UK inflation closer to the Bank of England’s inflation target of 2 per cent.
The data from the Office for National Statistics shows annual inflation has risen by 20 basis points since December’s rate of 1.6 per cent.
While this is the fourth consecutive month that the CPI index has risen, it has done so slightly below initial forecasts of 1.9 per cent. The ONS says the rise in inflation has mostly been caused by an increase in fuel and food prices, while it has fallen short of predictions due to a fall in clothing and footwear costs compared to this time last year.
Given inflation rose to just 0.3 per cent this time last year, does this mean the CPI will continue on its upward trend over the medium term?
Ian Kernohan, economist at Royal London Asset Management, believes it will and expects the index to continue rising further and even move above target this year, given the impact of sterling’s fall will take time to feed through.
“This will squeeze real earnings growth to close to 0 per cent, unless wages rise by more than we expect. We see no interest rate increase from the Bank of England this year or next,” he said.
Viktor Nossek, director of research at WisdomTree, says the UK has been hit by a “double whammy” of bad inflation from energy and food, which has been exacerbated by sterling weakness.
Performance of index over 1yr to February 2017
Source: FE Analytics
That said, he doesn’t believe CPI inflation will soar much above its 2 per cent target over the medium term because oil prices have lacked momentum, despite oil cartel OPEC’s cuts to supply.
“Indeed, the signs are that economic activity could weaken in the near term as the UK’s dominant services sector is slowing down, keeping a lid on demands for higher wages,” he warned.
“The 2 per cent target therefore represents something of a ceiling for CPI unless we see either of those dynamics change.”
James Klempster, head of investment management at Momentum, says the weakness in sterling is clearly making itself felt in consumer prices. He adds that general global commodity strength has also contributed towards the latest inflation figure.
“The next key step is to see how much of this increase in prices can be included in wage negotiation otherwise we will start to see consumers feeling the pinch in their pockets,” he warned.
“Even a small increase in inflation, if persistent, has a material impact on savers over the long term. That is why we believe it is imperative to invest today in a strategy that aims, deliberately, to generate returns in excess of inflation as this is the best way to put your savings and investments on the path to financial wellness.
“With the Trump reflation trade, higher growth, a pickup in inflation and greater certainty around the Brexit process dominating markets, we expect equities to continue to outperform bonds through 2017.”
Architas investment director Adrian Lowcock adds that, while inflation has undershot market expectations, it is expected to keep rising and peak at 2.8 per cent in 2018.
As such, he says inflation protection should be prioritised by investors and savers that are sitting on cash.
“The biggest challenge is finding the right investments. Because inflation had been widely anticipated to rise the markets have already driven up the cost of inflation proofing,” the investment director said.
“Index-linked bonds for example are already pricing in rises in inflation which we believe makes them expensive as we expect inflation to under shot current forecasts.
“We believe inflation is only temporary as the effects of a weak pound and recovering oil price work their way through the system. However, in order to protect their wealth, investors still need to ensure they have assets which can raise their prices in even mild inflationary environments.”
Performance of index and currency vs US dollar to February 2017
Source: FE Analytics
While Ryan Hughes, head of fund selection at AJ Bell, says index-linked bonds could be a potential bolthole for investors, he believes equities should be the preferred asset class for an inflationary environment.
“Equities’ relationship with inflation is all a matter of degree – a little inflation can be good but lots of inflation is bad, at least if history is any guide,” he explained.
“If inflation does take hold but does not zoom off to the double-digit levels of the 1970s then it would seem reasonable to expect stocks to outperform bonds, especially as the skinny yields currently offered by vanilla sovereign bonds in particular would be swiftly eroded in real terms by the surge in prices.”
Hughes also says equity income funds can provide more of a buffer against inflation, as well as funds that adopt more of a quality growth focus.
David Absolon, investment director at Heartwood Investment Management, says he expects developed sovereign bond yields to drift higher, given that headline inflation and market-implied inflation expectations are likely to continue to rise in the near term.
“We have maintained a long-standing short duration position and recent data appears to have reinforced our more cautious view on interest rate markets,” he said.
“We will look to find value in those areas of the fixed income market that will benefit from an improving global economy, such as less duration sensitive high yield credit and emerging market sovereign debt.”
In terms of property, BrickVest’s Agate Freimane says it is unlikely the latest inflation numbers will have a significant impact on the commercial or residential real estate market over the short term.
“Typically inflation means higher construction costs, which would eventually lead to increase in real estate prices,” she said.
“However, since the Brexit vote, the demand for real estate, both commercial and residential, has softened, so it is unlikely that developers will immediately pass on the raising costs as a consequence of the inflation to the end customer.
“In the construction sector, the inflation has been driven by weak British pound affecting the price of imported materials."
For those who are retired, Prudential’s Vince Smith-Hughes says it is important to reconsider how budgeting and how often income is drawn down, given the expectation that inflation will continue climbing.
He said: “Inflation has been consistently rising over the last three months, which will squeeze the living standards of retired people living on a fixed income, particularly as they often spend a disproportionate amount of their income of fuel, food and heating.
“Pensioners drawing down an income from their pension funds and savings will have to think again about how much they draw from their funds, particularly with the volatility we are seeing in investment markets.
“Increasing the amount of income they are taking from their pension or savings to meet the rising prices means they run a greater risk of exhausting their pension and savings.”