Jonathan Marriott, Chief Investment Officer
Whilst the recovery of the pandemic has been greatly welcomed, we have seen figures this week that demonstrate the differences in the nature of the recovery globally. Across the pond inflation appears to have peaked two months ago in the US and is gradually falling back. Meanwhile in the UK, inflation continues to rise and is not expected to peak until the end of the year.
Supply constraints remain difficult, however the US inflation data published this week showed some of the transitory effects abating. Core Consumer Price Index (CPI) excluding food and energy has fallen from 4.5% two months ago, back to 4.0% Bloomberg. Second-hand vehicle prices which rose around 45% in the year to June have been virtually unchanged for the last two months. This is a reminder that for inflation to remain high, price rises must repeat themselves. If second-hand car prices had continued to rise at the earlier pace, they would have been more expensive than new cars which is not sustainable. With US COVID-19 cases driven by the Delta variant rising again, this may give the Federal Reserve (Fed) a reason to be more cautious about tapering their bond purchases. Following comments from Fed officials, tapering is on the cards, but they may yet delay an announcement until the November meeting. This will add extra focus for the Fed meeting on 22nd September.
In the UK, CPI, whilst lower than the US, has risen to 3.2% year on year from just 2.0% the previous month. Core CPI has made a similar move and the old Retail Price Index (RPI) is up 4.8% from 3.8% previously. The base effect plays a larger part here as the UK removed restrictions later last year compared to other countries. Given the uncertainty and concerns about travel restrictions, domestic accommodation prices rose sharply over the summer holidays. In addition, the “eat out to help out” scheme was an effective tax cut last summer. The reversal of this, combined with the supply chain difficulties, partly due to Brexit, have pushed hospitality prices sharply higher. Rises in gas and electricity prices will be felt in the coming months more acutely given the rise in the energy prices cap. As a result, we expect the peak in CPI to be towards the end of the year and may be more prolonged than in the US. The latest news of a fire disrupting the supply of electricity from France, with potentially reduced capacity, does not bode well for the cost of utilities and will hamper further consumer spending.
The fire in France combined with low winds highlights the precarious nature of the UK power supply. The Government is urging individuals to switch to electric cars and heat houses using heat exchangers, in a bid to move away from fossil fuels and to adhere to the UK’s green industrial revolution. This will increase electricity demand when we may be facing shortages already this winter. We need to increase generation capacity, and therefore will need more than wind and solar energy that are weather dependent. The aim is to switch to electric cars in ten years’ time but getting new generation capacity may take longer.
While we expect the deflationary effects of technology, globalisation and demographics to reassert themselves over time, the UK may be more prone to inflation in the short run. The lack of lorry drivers and cheap labour from the European Union may also add to the pressures in the labour market. As the furlough scheme ends, this may ease the shortage in the jobs market.
The outlook for central banks is further complicated by government actions. In the US, proposed tax rises may constrain the economy, but the infrastructure spend will boost economic growth in the long-term. Whilst in the UK, tax and energy price rises may constrain economic growth and give the Bank of England reason to pause for thought.
Finally, a word of caution: those concerned about UK inflation may be considering buying UK inflation linked bonds. These already price in RPI inflation at 3.75% for ten years, well ahead of the Monetary Policy Committee target. The market as a whole has a duration of over twenty years which makes it very sensitive to rises in bond yields. It has also been announced that the calculation of RPI is moving to be more aligned with CPI which has been historically lower. The ten-year bond currently returns inflation by less than nearly 3%. Overall, not a good return and we do not recommend this trade.
 Bloomberg, Bureau of Labor Statistics
 Bloomberg, Office for National Statistics
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