March Inflation Through Markets’ Eyes

Editors’ Note: The cost of living has become an increasingly partisan topic. Our discussion—like MarketMinder Europe generally—is nonpartisan, favouring no politician nor any political party. We assess developments and policy prescriptions solely for their potential market or economic impact (or lack thereof).

UK inflation hit a fresh high in March, this time with the Consumer Price Index (CPI) rate clocking in at 7.0% y/y.^[i] Worse results are likely in store, given the energy price cap is scheduled to increase in April, which will likely burden households nationwide—a development we are very sympathetic to. The political rhetoric has also heated up, especially with the National Insurance Contribution increase beginning and income tax bands frozen, potentially exposing more people’s income to the Higher Rate of tax. Several commentators we follow warn this cocktail of negative developments will truncate the UK’s economic recovery and create trouble for stocks. We don’t dismiss the burden higher costs and taxes will place on many households. Yet when assessing the stock market, we think it is crucial to tune down emotion and focus on the question at hand: Is elevated inflation a big enough negative surprise to render an economic outcome worse than is broadly expected today? We don’t think it is.

Higher costs aren’t good. For households on a tight budget, this can be very problematic indeed. But the drivers are well understood. Given the war in Ukraine’s impact on oil and agricultural commodity prices, food and energy were large contributors to March’s faster inflation. These are widely—and rightly—seen as a headwind for households, as they constrain family budgets.

Yet spending on food and energy is still spending—it counts positively in gross domestic product (GDP, a government-produced measure of economic output). Higher prices may limit spending on discretionary goods and services, but as we wrote a few weeks back, the effect historically hasn’t been very big. For one, according to the Office for National Statistics’ Family Spending Survey, food and energy were 9.9% and 8.0% of weekly household spending, respectively, for the financial year ending March 2020 (before lockdowns crashed oil prices).^[ii] The extent to which households will have to make adjustments will depend on whether and how much their after-tax incomes rise alongside the prices of their daily essentials.

According to the Bank of England, wage growth hasn’t quite kept pace with consumer prices, but the average 5.4% year-over-year growth in the three months through February (the latest figures available) does help offset some of the consumer price increase.^[iii] Now, we recognise that average figures don’t represent every individual household’s experience. Some families may have seen larger pay increases—and some smaller. However, the average data do indicate UK households’ purchasing power likely has some resilience, in our view.

Monthly economic output data—primarily GDP—publish about a month behind the inflation releases, so the latest data we have right now are for February, when GDP grew just 0.1% m/m.^[iv] That contributed to many commentators we follow warning that a recession will begin soon. Whilst that is possible, we think some of the report’s underlying details offer more encouragement. For one, the primary detractor was the -3.8% m/m drop in human health and social work activities, which stems from the end of the National Health Service’s (NHS’s) COVID testing programme and a drop in vaccine take-up.^[v] As the ONS noted: “The NHS Test and Trace and COVID-19 vaccination programme detracted 1.1 percentage points from gross domestic product (GDP) growth in February 2022. This was driven by large falls in both NHS Test and Trace (falling 47%) and the vaccination programmes (falling 65%) … . It is important to note, though, that this follows particularly high levels of activity in December and January reflecting the vaccination booster campaign and high rates of infection from Omicron.”^[vi] Said differently, without the impact from lower NHS spending on the pandemic, monthly GDP would have risen 1.9% m/m.^[vii] Output in consumer-facing services grew 0.7% m/m, compounding January’s 2.0% growth.^[viii] These are inflation-adjusted figures, which we think shows how resilient the UK economy has been to rising prices thus far.

As for the stock market, our research finds stocks often do better than other asset classes at keeping pace with (and even exceeding) consumer prices. For instance: Whilst consumer prices rose 7.0% in the 12 months through March, the MSCI World Index returned 15.4% over the same period—including this year’s early correction (sharp, sentiment-fuelled decline of -10% to -20%).^[ix] The MSCI UK Investible Market Index, perhaps more relevant when discussing UK-specific inflation measures, rose 14.5%.^[x] Hence, whilst inflation accelerated, stocks provided a pretty good inflation hedge, in our view. With that said, we are in a correction now, but in time, we think rebounding stocks are likely to cushion investors against rising prices about as well or better than any other similarly liquid asset class out there.

Again, we know inflation can be painful. We hate it, too. But we think tuning down these emotions is key to navigating markets over time. Humans hate inflation, but in our view, stocks are able to take it in stride.