A drop in the UK inflation rate has taken some fund managers and analysts by surprise, but they expect the Bank of England to continue with base rate hikes later this year.
The consumer prices index (CPI) 12-month rate fell to 2.5 per cent in March from 2.7 per cent in February 2018, according to the Office for National Statistics (ONS), confounding many analysts’ expectations of an unchanged rate.
CPI over 10yrs
Source: ONS
According to the ONS, the largest downward contribution to the inflation rate between February and March was clothing and footwear.
Prices increased by just 0.7 per cent compared with a 2 per cent rise a year previously, although it noted that last year’s rise had been relatively large compared with previous years.
The ONS also highlighted a large downward contribution to inflation from the alcoholic drinks & tobacco sector.
This was in part due to tobacco duty rises that took effect in March 2017 not being repeated this year. Indeed, tax changes are now announced in November after changes to the Budget cycle instead of March.
A downward contribution from alcoholic drinks came mainly from spirits, which the ONS said tend to be influenced by sales patterns.
David Page, senior economist at AXA Investment Managers, commented: “While we have forecast a fall in CPI inflation over the coming quarters as the sterling’s sharp post-Brexit decline fades, CPI inflation is retreating more quickly than we expected.
“Part of this reflects idiosyncratic features – weather and lack of utility tariff hikes – but part may reflect weaker underlying inflation pressures.
“The timing of Easter also looks set to see inflation fall back towards 2.0 per cent in April, before rising to around 2.3 per cent around mid-year.”
Despite the fall in inflation, CPI remains above the Bank of England’s target rate of 2 per cent and, as such, many managers and analysts believe a rate hike in May is still highly probable.
Edward Park, investment director at Brooks Macdonald, said: “This is perhaps surprising given the Bank’s primary function is to control inflationary pressures which are showing signs of receding, however we think the health of the consumer plays a part.
“With real wage growth taking some pressure off consumers there is arguably now more room for the Bank of England to raise rates as consumers are able to bear the increased borrowing costs.”
Park added: “Alongside slightly weaker economic data in the last month the Monetary Policy Committee certainly has a more difficult decision to make in May. However, a hike still looks more likely than not.”
Employment data from February revealed a rise in regular pay growth, which when coupled with lower inflation suggests real wage growth.
Between December 2016 to February 2017 and December 2017 to February 2018, both regular pay and total pay increased by 2.8 per cent, in nominal terms, according to the ONS.
Great Britain nominal average earnings annual growth rates, seasonally adjusted
Source: ONS
“The interplay between wages and prices will be interesting over the coming months,” said Ben Brettell, senior economist at Hargreaves Lansdown.
“Inflation looks to be falling back as predicted, but with wages picking up and unemployment still falling, it’s possible this tightness in the labour market could eventually push inflation back up.
“Higher wages mean more money chasing the same amount of goods and services, which could lead to higher prices. At the same time firms might choose to pass on higher staff costs to the end consumer.”
Brettell said the “wage-price spiral” underlines the case for higher interest rates, although he noted that the central bank is targeting inflation “in two years’ time, not today”.
The resumption of real wage growth could see some previously unloved sectors of the UK market start to provide some interesting buying opportunities.
“With consumer spending accounting for more than 60 per cent of UK GDP, the resumption of real wage growth will clearly benefit the domestically exposed sectors of the UK equity market,” said James Illsley, UK equity portfolio manager at JP Morgan Asset Management.
“Structural change will continue to challenge established business models – the move to internet based retailing, the increased propensity to spend on experiences and travel versus physical goods and oversupply in some restaurant sectors.
“However, rising real wage growth will give a further boost to the successful operators and a lifeline to those companies trying to adapt.
“Many domestic UK stocks are cheaply valued and this news may be a catalyst for investors to look with fresh eyes at the sector.”
Performance of index over 1yr
Source: FE Analytics
As the above chart shows, the FTSE All Share Consumer Goods index has lagged the FTSE All Share over the past year, making a loss of 10.25 per cent compared with a return of 3.01 per cent for the broad index.
Juliet Schooling Latter, research director at Chelsea Financial Services, said higher wages are likely to hurt some companies dependent on higher staff numbers, but should be positive for the domestic economy.
She added: “Given that the UK is the only developed market economy to have had its growth estimate lowered, a wage rise and an increase in consumer spending power could be seen as a net positive.
“It’s early days yet, but worth keeping an eye on wages and inflation as a whole, just in case the growth rate accelerates. For now, it’s a case of keeping calm and carrying on.”