23 May 2022
Talk of inflation is everywhere, it’s the number one topic driving news, markets, and investment decisions. The latest UK inflation rate is now a staggering 9%, the most elevated of all the G7 (Group of 7) countries and a 40-year high for the UK and if that’s not enough to bring you out in a cold sweat, there’s an expectation of it reaching the dizzying heights of 10% in the coming months.
When it comes to central banks the knock-on effect is considerable. In the US, central banks have a remit to control inflation and employment levels. As levels of unemployment are currently low and wages are on the increase, interest rates are likely to continue to ramp up. Central banks in the UK focus solely on inflation indicating that the UK could respond even more aggressively than their US counterparts.
This scenario clearly has a significant and broad impact on markets but some asset classes such as equity and fixed income are affected more than others. What do higher interest rates mean for debt holders? With the latest average house price figure at £278,000 in the UK, which is £24,000 higher than this time last year and represents a 9.8% increase over the year, the housing ladder has become an even more daunting place. You’ll need to find more disposable income to pay the interest on your mortgage each month and you’ll have to step up again if you want a fixed rate for longer. There are a few lifetime mortgage products available that cost even more but they remove the unpredictable which, in the current environment, isn’t to be sniffed at.
Not surprisingly the word ‘recession’ has reared its ugly head and there are concerns about a drop in economic growth levels. If that scenario becomes reality, can interest rates continue to rise when there would be further negative impact on growth levels? Positive returns in fixed income markets generally mean that there’s scepticism about how far rates can go up. Will there be a point where we reach a peak in terms of fixed income yields? Predicting the turn of events is never easy but is it worth locking yourself into a long-term mortgage with these factors in mind?
How are students and graduates affected? The RPI figure sets the interest rate for the coming academic year, which means it will leap from 4.5% to 12% from September 2022 - the highest rate seen since tuition fees for university students in England were raised to £9,000 in 2012. In March 2023 a cap on the interest should kick in so the long-term impact on repayments may not be huge but until then, the higher rates will mean incurring almost £2,300 in interest (based on a balance of £50,000) for a graduate earning below £27,295 and £3,000 for a high earner over the 6-month period.
How does inflation impact consumer spending? Some people have saved over the last couple of years and are now making up for lost time when it comes to spending. Sales have increased but not enough to offset costs and consumer staples companies such as Walmart are seeing their margins squeezed. These businesses have pricing power and have generated consistent earnings making them attractive to investors over the last decade, but high inflation is now causing the tide to turn. Some companies will be able to pass on the increase in costs to customers but with inflation running so high, will consumers then reduce what they’re spending? The road ahead may well be rocky for consumer-facing companies.
Consumers would be in a better position to maintain spending if wages were increased. Employment rates are high and the number of job vacancies in the UK and the US has gone through the roof. The latest annual wage growth figure is 7% (including bonuses) representing a strong rise comparative to pre-pandemic levels but it’s still below inflation, illustrating an overall decrease in earnings and a reduction in consumer spending power.
The adverse impact of inflation is gradually filtering into and affecting everyone’s lives and with an expectation of further inflation and a reduction in economic growth levels, the economic landscape is far from rosy. What does this mean from an investment perspective and how can investors navigate this environment?
Fund managers from the latest Bank of America survey have significantly reduced their equity exposure and increased their cash ratings. Cash doesn’t give you real spending power, but it does give you the option of buying something at a lower level down the line. A shift towards cash doesn’t protect you against inflation but it does mitigate risk. You may also be able to limit the impact of inflation by considering the type of equities you’re buying and re-assessing your fixed income allocation in the short-term. If you think rates will continue to go up and market pricing is wrong, you may concentrate on shorter-dated fixed income or specific inflation-linked fixed income. If you believe inflation will moderate and interest rates will not rise as far as markets are currently pricing in, fixed income is beginning to look more attractive and increasing your allocation in this asset class may be worth deliberation.
Active management has the potential to do well in this unstable environment – the ability to avoid what you think won’t work and emphasise the areas that you think will – but care will need to be taken when it comes to the type of stocks you hold and the sector exposure you have and at portfolio level, the current climate may prompt a full reappraisal. The next decade is unlikely to resemble the last and you’ll want to ensure that you’re invested in the winners of tomorrow rather than those of yesterday.
Stewart Smith, Head of Portfolio Services
Katie Poulson, Client Engagement & Marketing Manager
QUIZ QUESTION: What was the average cost of a home in the UK in 1980?
LAST WEEK'S ANSWER: 38% of UK adults have sought independent financial advice at some point in their lives.
RSMR provides impartial, qualitative, forward-looking research for advice businesses.
Click here to head to the RSMR blog for market updates and a whole host of informative, up-to-the-minute content.
Click here to sign up to RSMR research where you can access RSMR fund ratings, fund profiles, factsheets, insights, market updates and event information.
This information is for UK Professional Advisers only and should not be given to retail clients.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
Rayner Spencer Mills Research Limited is a limited company registered in England and Wales under Company Registration Number 5227656. Registered office: Number 20, Ryefield Business Park, Belton Road, Silsden, BD20 0EE. RSMR is a registered trademark.