A key driver of inflation is the much weaker pound which, since the UK is a net importer, has meant that goods imported from overseas are now more expensive than before sterling fell.
Rising inflation is a natural consequence when the cost of importing is increasing owing to the weak pound. A persistently weak pound will have long term implications on the inflation outlook and this will affect business and consumers across the UK and therefore attitudes to investing.
Inflation is a key concern to investors in FTSE 250 companies because this index focuses predominantly on the UK. With sterling having fallen over 15% on a trade weighted basis this has effectively made buying from overseas 15% more costly for UK firms and consumers. That means the companies the FTSE 250 represents will feel a greater impact from the effects of rising Inflation and a weak Pound. Businesses which purchase raw materials or import services from overseas will find their cost base going up and be forced to raise prices as they seek to protect profits whilst consumers will be holding back on spending or have less to spend.
The outlook for the UK is higher inflation as we are likely to see the pound fall further or remain weak owing to the Brexit vote, and lack of clarity over any deal and the long term implications for the UK. This week it was reported inflation has risen from 0.6% to 1% from August to September. Sterling didn’t change dramatically between August and September but there will be a lag between inflation rising and sterling’s performance. Prices in the shops don’t rise on the day sterling falls, it takes time for real prices to adjust.
But the fact we saw a 0.4% increase in inflation across two fairly similar months of sterling performance indicates we should be concerned about the change in Inflation from September to October and beyond – since September sterling has fallen around 6%. Investors in the FTSE 250 should be anticipating which companies will benefit from this and which may suffer.
We have already seen headlines warning of supermarkets raising prices and somewhere along the line the 15% fall in sterling will impact the UK, which is a net importer. For companies that report profits in a foreign currency or earn in foreign currencies there will be good news. This explains the FTSE 100’s record performance. It is interesting to compare some of the more UK focused businesses on the FTSE 100 which are not faring as well as those with more global interests, a clear sign that it is the pound’s weakness driving the good news.
Unfortunately, as a net importer the UK fails to benefit overall from a weaker pound. The resulting higher inflation is not good news for anyone filling their car with petrol once a week or doing a weekly shop. Investors in the FTSE 250 should perhaps be taking this on board and looking to aim for companies with more global presence. They should be careful of firms which have a heavy reliance on importing from overseas and perhaps invest in exporters. Manufacturing posted some record results as the weak pound helped boost trade deals with UK companies exporting their wares across the world.
Corporate profits for certain businesses will undoubtedly be squeezed as will dividends. Some companies might try to use the uncertainty to boost dividend payments as a sweetener to retain investor interest during what might become a challenging period.
Lower profits at FTSE 250 companies means less dividends and in general a more mixed outlook on interest rates. The more immediate prospect of interest rates falling has shifted but depending on the impact to business on growth this could become an issue. Interestingly, the Bank of England has anticipated the rising inflation rate and has suggested they will look through the higher inflation rates when deciding on monetary policy.
Inflation will affect attitudes towards the raising of interest rates; it could be that whilst at present a higher inflation rate would increase calls for a rate hike as we approach the Bank of England’s target of 2%, inflation will be allowed to rise higher, which will weigh further on the FTSE 250 companies and the public.
Without the necessity to raise interest rates to calm inflation, investors and businesses can take further advantage of low interest rates. It remains to be seen how high an inflation rate the Bank of England will allow before discussing the prospect of raising interest rates. I think it will depend on growth and employment, both of which are fairly robust four months on from the Brexit vote.
Should we start to see any signs of falling growth and rising unemployment, interest rate cuts or Quantitative Easing could be back on the cards, which would weaken sterling and keep Inflation high. It might be that high inflation becomes an acceptable face of the UK despite its obvious negative effects on the economy, business and consumers.
Infrastructure spending from the Government could see some unexpected windfalls for some companies in the construction sector although the termination of the Government’s Help To Buy Scheme at the end of 2017 is perhaps sending a mixed message.
Faced with rising costs many businesses will be forced to raise prices and this will increase competition between firms. Companies paying dividends on overseas earnings seem a safe bet whilst some of the more ‘value’ branded firms may benefit too as consumers tighten belts. Industries reliant on tourism could see increases for individuals coming to the UK but suffer on reduced holidays for Brits seeking to holiday abroad.
A weak pound and higher inflation will have wide ranging consequences for FTSE 250 companies which are likely to be exacerbated as sterling remains on the back foot. Some well-placed investments now could pay big dividends for the future in a clearly volatile yet exciting period for the UK.
Prepared by Jonathan Watson, Chief Market Analyst at www.currencies.co.uk