It's tempting to react to this by shifting out of cash and into equities. Such a temptation should be resisted.
Two simple historical facts warn us of this.
One is that cuts in Bank rate have, on average, been bad for equities. Since January 1998 there has been a statistically significant positive correlation between annual changes in Bank rate and returns on the All-Share index: 12-month periods in which Bank rate falls are, more often than not, associated with falling share prices. On average in this period, a one percentage point fall in Bank rate has been accompanied by 5.5 percentage point lower returns on equities.
Secondly, there's been a negative (though weaker) correlation between annual changes in CPI inflation and equity returns. Higher inflation is usually associated with lower equity returns.
These two facts tell us that rising inflation and a falling Bank rate are usually both bad for shares.
In the case of Bank rate, there's a simple reason for this. The Bank cuts Bank rate, and holds it down, when it is worried about the economy. But investors usually share these concerns - which means that equities often do poorly.
To see why inflation is often bad for equities, remember a distinction which was popular in the 60s and 70s - between "demand pull" and "cost push" inflation.
If inflation were to rise because of stronger demand, equities might well do well, because such growth would raise corporate earnings and investors' appetite for risk.
But this is probably not what we'll see next year; economists have cut their forecasts for GDP growth from 2.1 per cent to 0.8 per cent. Instead, what they think we'll get is "cost push" inflation: sterling's fall will raise the prices of commodities and imports. Such higher costs will squeeze real incomes. That's bad for equities.
It happens to have been the case that since the late 90s the inflation we've actually had has been slightly more "cost push" than "demand pull", which is why there's been a slight negative correlation overall between changes in inflation and changes in equity prices.
You might object that rising inflation and weaker growth next year are already discounted by share prices. I'm not so sure. For one thing, there's the problem of projection bias. Investors might be projecting their present highish appetite for risk into the future, and so are underestimating the likelihood that slower growth will make them more risk-averse. Also, there's a certainty effect; the likelihood that rising prices will squeeze real incomes is qualitatively different from the lived experience of it actually doing so - an experience which might also cause increased risk aversion and falling share prices.
All this poses the question: what hope, then, is there for investors? One possibility is that the rise in inflation will be small and temporary. A silver lining to the cloud that is a weak economy is that a weaker labour market might prevent higher prices from triggering a wage-price spiral.
Aldo, equity returns do not depend upon the fate of the UK economy alone, If global growth picks up - as the IMF predicts it will - equities might benefit from a rise in global investors' appetite for risk. There is, remember, a strong contemporaneous correlation between All-share returns and US industrial production growth.
There might, therefore, be reasons to buy UK equities. But let's just be clear: these reasons do not include the fact that real returns on cash are about to get even worse.
