One of the safer bets for 2017 is that inflation will rise. The Bank of England expects consumer price inflation, which is currently 1.2 per cent, to rise to 2.8 per cent by the end of the year. What does this mean for equities?
You might think: nothing. Inflation is often quite predictable, at least on a 12-month horizon: this is because changes in inflation are due as much to past price changes dropping out of the data as to new developments. The prospect of rising inflation should therefore be already discounted by the stock market.
History suggests you'd be largely correct. Since 2000 the correlation between the annual inflation rate and annual changes in the All-Share index has been just 0.1, which is statistically indistinguishable from zero. As you'd expect, therefore, many sectors have a near-zero correlation with inflation. These include financial stocks, tech stocks, retailers, telecoms and tobacco.
All this is consistent with the market discounting changes in inflation in advance.
There are, however, some exceptions to this.
|Sectors' correlations with CPI inflation|
|Oil & gas||0.16||2.11|
One is commodity stocks. Oil and mining stocks are positively correlated with inflation. This might be because they benefit from some of the things that usually cause inflation, such as higher commodity prices, stronger global economic activity and a fall in sterling which raises overseas earnings.
However, even here correlations are quite low - and not strong enough to form a basis for stock selection.
Instead, there are two other beneficiaries of higher inflation: chemicals and engineers. For example, each percentage-point above-average inflation rate is associated with engineers' returns being almost ten percentage points above average. This might be because the same weak pound that causes inflation can also increase the profit margins of exporters, and in these cases investors initially underestimate the size of this benefit and so get a pleasant surprise when inflation rises.
Each percentage-point above-average inflation rate is associated with engineers' returns being almost ten percentage points above average
On the other hand, though, there's one sector that tends to lose from higher inflation: construction. I suspect this is because it suffers from the higher wage growth that often accompanies price inflation and because it doesn't benefit as export-oriented sectors do from the weak pound: quite the opposite, as it suffers from higher import costs. Also, higher inflation should bring with it expectations of higher interest rates, which hurt construction more than most.
Even in these three cases, however, correlations are not especially high. Stock-pickers might want to have a slight bias towards exporters and against construction if they fear rising inflation. But strong bets don't seem to be justified by the historic data. Sometimes, the market does indeed do a reasonable job of discounting developments in advance.
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Chris blogs at http://stumblingandmumbling.typepad.com