Join our community of smart investors

Inflation's unsettling presence

Inflation remains at the forefront of investors’ minds, and continues to divide opinion. The latest figures from the Office for National Statistics (ONS) show consumer price index inflation (CPI) hit 5.4 per cent in December, higher than most economists expected. In the US, consumer price changes are now running at a very hot annual 7 per cent (and the fastest rate of increase in almost 40 years). 

Both numbers mean a stream of interest rate rises as central banks try to put this fire out. Rate rises will take time to have an effect and as Martin Lawrence, a director at mutual Wesleyan, comments “inflation is like a bad cold – it will get worse before it gets better”.

We’ll soon discover how the Bank of England intends to respond. Its next meeting to weigh up the ONS data takes place on 3 February. Capital Economics, which thinks inflation will peak at 6.9 per cent in April, expects at least three rate hikes by the Bank this year, starting with one at that next meeting. The Fed is expected to raise rates at least three times over the coming year, or as many as “six or seven times” if you are JPMorgan.

But when will inflation fall? The transitory camp tells us later this year, once energy price hikes fall out of the calculation. Currently they are a significant contributory factor to the inflation spike. Morgan Stanley’s chief US economist, Ellen Zentner, is clear on this: “The key distinction in our minds is that temporary inflation is measured in multiple percentage points whereas the permanent rise in inflation is measured in tenths.” 

But the higher-for-longer inflation camp points out that the vast quantities of money injected into the system will continue to push prices in the wrong direction, while rising oil prices stemming from geopolitical tensions in the Middle East could also prolong the pain. 

Investors continue to waver on the US tech sector, but with no such sector to speak of, or bubble worries, could the UK market get off more lightly? Certainly it has outperformed the US recently thanks to its high weightings in financials, mining and energy, all sectors that have got off to a flying start this year. There has been a healthy rise in gross domestic product (GDP) too, taking the economy back to its pre-pandemic level, and the ONS says construction sectors have been finding it easier to secure raw materials. Meanwhile, a Hargreaves Lansdown survey found optimism about UK assets has grown, with investor confidence up 4 per cent in December compared with November on the “expectation that the weighting of listed companies towards the mining, energy and financial sectors should start to bear plumper fruit”. 

Ultimately, what inflation-wary investors will be looking for across the sectors are companies with pricing power and, as Algy Hall points out in his inflation-beaters stock screen on page 46, that go-to metric of inflation-resilient businesses: high gross margins. These are both highly favoured by Stephen Yiu, lead manager of the LF Blue Whale Growth Fund. Microsoft is his favourite example of a company with pricing power, but he agrees this power is only part of the story. Gross margins matter too. What he wants to see are low external costs of running the business compared to revenue because these cannot be controlled by the company. His fund has a weighted average gross margin across its investee companies of around 70 per cent, which means that, of the companies’ total revenue, there are external costs associated with running the business of 30 per cent. But UK blue-chips, he says, manage the inverse with a gross margin of only around 30 per cent, leaving them more vulnerable to inflation.