UK interest rates may come down but higher inflation is coming

Will the Bank of England cut interest rates by a quarter of a per cent this week, half a per cent, or stay the same? It doesn’t really matter. The key message for UK investors is that rates look set to remain “lower for even longer” than we thought.

Markets are pricing in rate cuts, but further fractional changes will not make much material difference for most of us. A rate cut is good news for people like me on tracker mortgages, but by my calculations, a quarter per cent cut on my monthly repayment will equate to a couple of drinks in the pub - hardly an economic rocket booster.

And savers have been feeling the pain of “lower for longer” rates for years. Data released by Moneyfacts this week showed that interest on savings accounts has hit record lows. The average one-year savings account pays a paltry 1.15 per cent, and that’s before any action from the Old Lady of Threadneedle Street.

Inflation

But economists and analysts are already warning that the combination of weak sterling, rate cuts and more quantitative easing can only add up to one thing – higher inflation. This is something that neither consumers nor investors have had to worry about for some time.

With sterling hitting a 31-year low against the dollar last week, the expectation is that falling rates and continued uncertainty over Brexit negotiations will push the currency lower still in coming years.

Sterling bears predict the pound could fall a further 10 per cent against the dollar. If this were to happen, Deutsche Bank projects UK inflation could break through its 25-year high of 5.2 per cent in the next three years.

Under a less extreme scenario, its analysts still see consumer price inflation (CPI) rising above 3 per cent in that timespan. Others are of the view that the effect of higher import prices will see inflation climb to 3 per cent by the end of this year.

UK retailers – already braced for an expected post-Brexit consumer spending slowdown – anticipate this will become their next big headache.

John Lewis has been one of the first to warn that consumers could face rising prices next year. Most major retailers have currency hedges to even out short-term fluctuations, so we won’t see higher prices in the shops overnight. But if you are planning to replace any big-ticket items in your home or embark on a major DIY project, this year’s summer sales could be the last time you can snap up a real bargain for a while.

Decision

Another key decision for many consumers will be whether to remortgage. The banks are already offering some tempting rates on longer fixes, so if you’re bobbing along on your lender’s standard variable rate (SVR) this could be another worthwhile project to explore this summer.

But investors have a tougher set of decisions to make. In a zero-rate environment against a backdrop of rising inflation, where is the best place to put your money?

With bond yields expected to come under further inflationary pressure, the obvious answer is equities for most income-seekers (despite the equally obvious risks of further volatility).

The popularity of so-called bond proxies – those “expensive defensives” or “port in a storm” investments with reliable dividends but full valuations – is likely to continue under this scenario, although this begs the question of how reliable those dividends will be if the economy takes a turn for the worse.

"Invest in things that you can touch – real assets, finite in supplies which retain their worth even when prices are rising," is the conclusion of Maike Currie, investment director for personal investing at Fidelity International. Expected changes to monetary policy and its effects will boost the appeal of infrastructure investment trusts, she says, and also swim against the tide of negative investor sentiment against property.

Risk

Retail investors may be herding out of open-ended property funds (or attempting to) but the predictable income stream offered by commercial property rents – which offer a degree of inflationary protection – will appeal to investors with a strong risk appetite who are prepared to take a long-term view.

Despite parallels being drawn between now and 2008, there is little evidence of excessive bank debt being used to finance deals, markets are hardly oversupplied and there is a material cushion between government bond yields and the income available from property.

Away from the calamity in the open-ended funds sector, shares of big property companies and housebuilders have started to recover some of their post-Brexit losses, though analysts caution this could be a rocky ride.

The changing market dynamics could also be good news for buy-to-let investors. They may have seen tax rises dent their profits, but for well-capitalised landlords, this could be offset by better mortgage deals and rent rises.

Auctions

For wealthier investors seeking more direct exposure, commercial property auctions also appear to be holding up. Just over £55 million was raised at the Acuitus commercial sale this month, with 87 per cent of lots offered successfully finding a buyer.

Chief gavel-wielder Richard Auterac stated that there was “no apparent difference” in pricing between the firm’s pre- and post-Brexit auctions. This indicates that despite the uncertain outlook for capital values, the income yields from this asset class alone are enough for serious private investors to keep calm and carry on buying.

Outside of the auction room, what can the average private investor divine from all this? If high-risk bets on commercial property are not your thing, then sadly the outlook for investment returns is broadly the same as interest rates – lower for even longer than we thought at the start of this year.

– Copyright The Financial Times Limited 2016