Inflation – how high can it go?

Soaring utility costs, higher fuel prices and rising manufacturing prices have caused inflation in the UK to rise to 5.4 per cent, its highest level for 30-years. Ollie Barnett, Director at Weatherbys Private Bank, asks Paul Dales, Chief UK Economist at Capital Economics, whether inflation will rise further and if so, what that means for interest rates and equity markets.

Key points:

  • inflation will rise further
  • inflation to remain above 2 per cent target level for another year
  • UK economy will recover – but growth will be slower
  • equity markets will hold their own in the short-term

How high will inflation go?
Inflation is going to go higher. It is already at 5.4 per cent, which is way above the Bank of England’s target of 2 per cent. It’s never been that far above the Bank’s target since inflation targeting began in the UK in October 1992. So, there’s a really big accusation that the Bank is missing its inflation target. We believe inflation is going to go a little bit above 7 per cent by April this year. Admittedly, inflation is probably going to fall back after the spring, but throughout 2022, we believe it will be above 4 per cent and that it won’t get to the 2 per cent target until April 2023. By that time, inflation will have been above the Bank’s target for a full two years.

Why is inflation rising?
You can’t escape the fact that utility prices are rising sharply. The implications are that utility prices are going to rise quite sharply in April when Ofgem reviews the utility price cap. That move will be a function of the surge in wholesale gas and electricity prices over the past six months. The average price for wholesale gas prices is about 240 per cent higher and wholesale electricity prices are around 140 per cent higher. This could result in utility prices paid by you and me going up by 50 per cent and will account for a two-percentage-point increase in inflation come April.

But it is not just utility prices that are causing higher inflation. Fuel price inflation is about 30 per cent a year, the same is true for second-hand car prices, while food price inflation is at a nine-year high. Global factors mean that manufacturers are having to pay far more for materials and components. This has led to higher selling prices, higher prices that are then passed on to customers by retailers. So, there are big increases in costs already in the inflation pipeline that have yet to filter through into the goods and services we buy.

It is going to be a tough time for households over the next six to 12 months, not forgetting taxes increases in April, but our analysis suggests it will not be as drastic or miserable a situation as it was in the immediate aftermath of the Financial Crisis.

What does inflation mean for the UK economy?
We think the overall economic recovery will continue as the pandemic moves further into the rearview mirror. However, there are two headwinds to this recovery. The first is the wave of Omicron cases that began in December and continued into January. And that’s probably going to take some heat out of the economic recovery as people stayed away from restaurants and pubs. From April, when utility prices go up and energy prices go up, households just won’t be able to spend quite as much. We believe the economy is going to grow at a slower rate than we thought six months ago when our inflation forecasts weren’t quite so high. The one crumb of comfort is that there are a lot of households who were lucky enough to have built up quite a big stock of savings during the pandemic. That stock of savings can be used to cushion the blow.

What does it mean for UK interest rates?
On the one hand, the Bank of England is dealing with an economy that is going to slow. On the other hand, it’s got inflation well above its 2 per cent target and rising. Historically, the Bank has put quite a lot of weight on a slowdown in economic growth – safe in the knowledge that if the economy slows, inflation tends to come down. But this time, it’s going to put much more emphasis on the higher rates. We saw evidence of that in December when the Bank raised interest rates for the first time since the pandemic. Given our forecast of rising inflation, we don’t think that the Bank will want to stand by and watch this happen. This explains why we have pencilled in four rates hikes to 1.25% by the end of the year, with a rise to 0.5% at the Bank’s next policy meeting in early February.

What does it mean for UK equities?
We expect that UK equity prices will do okay, but not spectacular. Typically, equity prices tend to do quite well at the start of an interest rate tightening cycle. That’s usually because when interest rates are about to rise, the economy is firing on all cylinders, which means companies are enjoying healthy profits. Also, higher inflation doesn’t do too much damage to equities because it can mean that their selling prices increase – so, profits go up in line with inflation.

However, the inflation we are experiencing is the wrong type of inflation. Inflation driven by high utility prices means that companies aren’t going to raise their selling price as much, but it does raise their costs. So, it might be a net negative for their profits and margins. Second, higher inflation will be accompanied by higher interest rates. When interest rates rise, they tend to reduce the future value of corporate earnings. This can be a headwind to equity prices.

Third, the makeup of the UK FTSE100 is quite heavy on things like energies, for example, which aren’t going to do that well. Bringing all that together, we forecast the FTSE100 will rise a bit further this year, to say 7600, but I don’t expect equity prices to be as strong over the next year as they have been over the past year. Valuations in the UK don’t look anywhere near as stretched as US equity prices. This suggests there might be some scope for UK equity prices to perform well over the next five years relative to US equity prices.

What does it mean for Weatherbys Private Bank clients?
At Weatherbys we build portfolios that make sense for the long-term objectives of our clients. Our portfolio construction is cognisant of ongoing economic conditions and the structure of the economy. If that structure changes, for example, if inflation does start to become a problem, we consider adjusting portfolios in response to that new reality or discuss with clients whether their investment profile is still appropriate or needs changing. 

In recent months, we have started using an assumption of elevated levels of inflation in our cash flow models for clients to see what that scenario would mean for them, and to give us the chance to recommend changes to their investments if appropriate.

We continue to believe that equities provide the best protection from inflation over the longer term. There is no investment asset that reliably protects against inflation in the short term, but many studies highlight equities tend to outpace inflation over the long term. However, it’s important to be aware that not all equities are the same, and depending on the environment, some stocks will fare better than others. The overriding message is to stay diversified and ensure that your investment portfolio(s) are positioned appropriately for your circumstances and objectives.

If you want to discuss how inflation may affect you, please get in touch using the form below to find out how we can help you.

Important information:
Capital Economics is an independent consultancy firm. Past performance is not a guide to future returns. Please note that the value of investments can go down as well as up, and you may get back less than you originally invested.