The latest financial markets update from Thomas Carroll’s Wealth Management team, in conjunction with our research partner, Square Mile, is here.
On Wednesday the 16th of August, it was announced that UK inflation has fallen to its lowest level in 18 months. In this short piece, we briefly explore the key drivers and what this may mean for interest rates and portfolios:
- Lower energy prices for both electricity and gas drove the sharp drop in July to 6.8%, from 7.9% in June.
- Food and non-alcoholic beverages price rises also dropped, with growth of c.15% versus c.17% from the month before.
- In many ways this is a relief and broadly what markets were expecting, as such there does not appear to be much market reaction to the news.
- Prices across the board are still up significantly on last year, and falling inflation is clearly not the same as falling prices.
- Underlying pressures persist with core inflation, which strips out food and energy prices, remaining the same from June, at 6.9%.
- Stubborn core inflation is largely due to the rising prices of services, which were 7.4% in July, compared to 7.2% in June.
- The latest data for wages in the UK shows that annual growth in total pay (including bonuses) was 8.2% in the three months to June, which was up from 7.2% in the three months to May.
- Food price inflation, whilst falling, remains high.
- Whilst there have been tentative signs that some banks and building societies are looking to reduce mortgage rates, we do not expect these to be large moves and may remain elevated, when compared to recent history, for some time.
- The interest rate and inflationary backdrop may also be behind the recent rise in unemployment, which came in at 4.2% in the three months to June.
The Bank of England will take all these factors into account, including the state of the housing market, when judging the outlook for interest rates. The larger-than-expected figures for wages coupled with the current levels of inflation means that the market believes that interest rates will rise by 0.25% in September. Furthermore, peak rates may now be 6% in early 2024, rather than the previously expected 5.75%. Market expectations have fluctuated quite a bit this year, being as high as 6.25% at one point. They will continue to evolve as further data is released but undoubtedly, in our opinion, the peak in rates is now close.
As the inflationary backdrop evolves, and could yet surprise to the upside, especially given the pace of wage increases, we continue to be slightly underweight fixed income. Higher than anticipated interest rates could put upward pressure on bond yields, which would mean that bond prices fall. This is also why we retain our overweight position to alternatives/absolute return solutions, which should be able to generate positive returns irrespective of the direction of inflation and interest rates; although this is a position we are continually reviewing, given the overall improvement in bond yields. Yet, we have tempered these stances recently by increasing the interest rate sensitivity of the portfolios, where relevant, for we believe we are edging closer to the peak in interest rates.
Whilst a global recession does not look imminent, we do not expect the inflationary or economic journey to be a straight-forward one, and it may be a case of a recession delayed rather than avoided. This is largely because interest rate increases are a fairly blunt tool with which to tame inflation, aiming to cool demand by making life increasingly expensive for consumers and companies alike. As such, there may be further corporate casualties to come, especially for the more indebted parts of the market. This is one of the reasons why low levels of debt are a characteristic we emphasise in our equity holdings. Yet, we balance this with
the fact that equity valuations have improved, and that the growth potential of stock markets means they are one of the few asset classes that can deliver returns ahead of inflation over the medium to longer term. Therefore, we are not positioned aggressively in equity markets but retain what we would term a neutral level of exposure in portfolios.
We will continue to be vigilant and look opportunistically to make changes to portfolios as and when these arise.