Adding Perspective on UK Inflation and Rate Hikes

Did the Bank of England (BoE) just overreact to hot videogame sales? That is one potential interpretation publications we follow provided of Thursday’s half-point rate hike, which policymakers pinned on May’s surprise inflation reacceleration … which, in turn, analysts have determined derived in part from robust consumer demand for the new Legend of Zelda game lifting recreation and culture prices.^[i] But instead BoE head Andrew Bailey once again blamed workers’ seeking higher wages and companies’ protecting profit margins for driving prices higher, fuelling commentators’ suggestions the UK’s inflationary pressures are somehow different and stronger than the rest of the world—and potentially necessitating rates to rise from today’s 5.0% to 6.0% or more by year end.^[ii] With this comes talk of a mortgage squeeze compounding cost-of-living pressures, potentially ratcheting up recession risk.^[iii] Yet for UK stocks, which flirted with correction territory this spring, none of this is surprising, new news, in our view.^[iv] These factors have been discussed, debated and dissected in publications we read for months. Rather, our historical market analysis suggests to us this is a classic case of UK markets zagging on sentiment whilst global markets zig. In our experience, divergences like this usually don’t last for long, and with economic fundamentals globally looking pretty good, in our view, we think the stage seems set for UK stocks to rebound.

The popular view espoused by commentators we follow is that with the UK’s headline consumer price index including owner occupiers’ housing costs (CPI-H) accelerating from 7.8% y/y to 7.9%—and core inflation (which excludes food and energy prices) speeding to a fresh high of 6.5%—the BoE hasn’t yet put a lid on prices.^[v] These observers further suggest that means more rate hikes are likely to come at a time gross domestic product (GDP, a government-produced measure of economic output) growth is mostly wobbling sideways, making recession a foregone conclusion as more mortgages come off their fixed-rate periods, exposing more and more borrowers to a sudden surge in monthly payments.^[vi] They further pair higher housing costs with the too-slow march to lower energy prices and stealth tax hikes, suggesting there isn’t much left over for discretionary spending and investment.

That, at any rate, is the going narrative from observers. We think stocks might seem to reflect this, too, at least to an extent: The MSCI UK Investible Market Index (IMI) is down -5.4% from its last all-time high on 16 February.^[vii]

But we would like to offer some counterpoints. One, we suggest considering CPI-H’s owners’ equivalent rent component. That is the same made-up cost that has been artificially inflating US CPI lately, and it is the primary culprit driving UK CPI-H higher last month.^[viii] (We say “made-up” because it is the amount a homeowner would theoretically pay to rent their own home, which is an expense no one incurs.) The UK’s legacy CPI, which most publications we read focus on, excludes this line item and, as a result, its 8.7% y/y inflation rate was unchanged from April.^[ix] As for the rest, food prices decelerated markedly, but it received scant discussion—perhaps because the big acceleration in recreation and culture prices offset it.^[x] The ONS pinned this on “computer games,” which points the finger squarely at Zelda.^[xi] Iin the same way a Beyoncé concert caused a one-off inflation surge in Sweden last month, a big cultural event can skew inflation data as prices respond to the temporary demand.^[xii] In our experience, it can be jarring in the moment, but it usually doesn’t last. Meanwhile, producer prices are down near a zero percent inflation rate, and broad money supply has spent five of the past seven months in contraction.^[xiii] So we think the stage appears set for inflation to keep easing regardless of BoE hikes.

As for the alleged mortgage time bomb, it is true that UK homeowners are exposed to rate hikes. However, pencilling in perma-pain rests on presuming the BoE will keep rates high indefinitely. We think the massing disinflationary forces argue against this, as does observers’ ever-present recession watch. We suspect we could be looking at a very different interest rate environment a year from now. Then, too, every borrower’s situation is unique. We think homeowners who have built equity thanks to surging home prices in recent years may have underappreciated refinancing flexibility. Chancellor of the Exchequer Jeremy Hunt also agreed some relief measures with bank executives Friday, including grace periods for repossession and temporary mortgage restructuring.^[xiv] So we are darned sceptical of commentators’ warnings about surging mortgage rates wiping out disposable income. You can hit a speed bump without crashing, especially if signs have warned of that speed bump miles and miles ahead of it. In our experience, people are darned adaptive when they see an issue and have time.

We aren’t arguing good news abounds in the UK economy. Our research shows it is muddling through and battling headwinds, even with the recent consumer spending upturn.^[xv] But, in our experience, stocks don’t need steadily good news. We think reality outpacing investor expectations is generally enough, and those expectations appear extremely low right now. Commentators’ good cheer that accompanied the recent upward revisions in the BoE’s and other outlets’ GDP forecasts?^[xvi] Vanished, replaced by the inflation doom and rate hike gloom we are seeing after the ONS’s recent report. Many commentators we follow continue to focus on wage/price spiral chatter (despite this theory being debunked by Milton Friedman decades ago), whilst very few acknowledge the aforementioned disinflationary monetary conditions.^[xvii] And absent seasonally adjusted month-over-month price data, we suspect it is too hard for most observers to disentangle base effects from fresh monthly wiggles, so, in our view, it may take some time before slowing inflation becomes more visible to investors. But there does seem to us to be a growing gap between sentiment and reality.

Therefore, to us, UK stocks’ decline looks sentiment-driven.^[xviii] The economy may have its problems, but, in our experience, growing global demand has a habit of pulling weaker countries along, and we think the UK looks primed to receive a tow from the US, Asia and other growing areas. So whilst UK stocks may be registering people’s feelings lately, we think they should have some decent fundamentals to weigh once fear gets more fully priced in. We anticipate global stocks also helping tow UK stocks. The correlation coefficient between the UK and the rest of the world is 0.86.^[xix] This is a statistical measurement of the directional relationship between two variables. Considering -1 means two variables always move in opposite directions, 0 means no relationship and 1 means they move in lockstep, a 0.86 correlation means they move together the vast majority of the time. That makes the past couple months’ divergence a very strange, unusual phenomenon—unlikely to last.

The relationship would be restored if global stocks started falling alongside UK markets, but that seems improbable to us. We think US stocks are climbing a big wall of worry right now, with scary stories from commentators we follow aplenty keeping sentiment low whilst better-than-expected economic results and political gridlock in the US Congress help stocks climb.^[xx] In our view, those positive forces aren’t going anywhere, making it more likely that UK stocks eventually resume climbing alongside the rest of the world. Whilst we think the turning point is impossible to pinpoint, looking 3 – 30 months out—as our research shows markets do—we think UK stocks are much likelier to be up than down. Maybe not up as much as the rest of the world’s, given the UK’s higher commodities weighting and relative dearth of Tech-orientated stocks, but up, in our view.^[xxi]

We find successful investing is often about looking past dreary headlines and weighing probabilities. When headlines are chock full of bad news, we think it helps to remember that, in our view, markets see it too and, over time, will likely move on the gap between the sentiment those headlines create and how reality actually shapes up. In our experience, perfection is neither mandatory nor possible. If the UK merely does less bad than investors expect, we think that should be enough for markets.