Over the past month, the blue-chip FTSE 100 has drifted sideways. Since 29 April, the Footsie has risen by roughly 70 points (1%), but has gained over 570 points (8.8%) in 2021. What’s caused this recent slowdown? One factor firmly at the front of investors’ minds is inflation (rising prices).
Higher inflation is bad for bonds
Inflation reduces the future spending power of a currency. For example, a yearly inflation rate of 2% means prices have climbed 2% in the past 12 months. This reduces money’s buying power, making your pound worth less. As inflation rises, it often feeds into pay demands (“One man’s pay rise is another man’s price rise”.) Also, rising prices are bad for bonds: fixed income debt securities. As prices rise, the fixed interest payments paid by bonds become worth less. Thus, as inflation rises, bond prices tend to fall.
UK inflation is rising
To avoid eroding the future value of money, governments aim to keep inflation under control. Thus, when inflation starts rising beyond central banks’ targets, they usually raise interest rates. For example, both the Bank of England and the US Federal Reserve have an inflation target of 2% a year. In the UK, the official measure is the Consumer Prices Index (CPI). If CPI rises above 2% for too long, then the Bank would increase its base rate to curb rising prices.
In March, UK CPI was 0.7%, but leapt to 1.5% in April (driven by higher energy, oil, and clothing costs). That’s the highest CPI since March 2020, when Covid-19 was spreading globally. However, part of this leap is down to ‘base effects’ from prices being suppressed during 2020’s lockdowns. Nevertheless, economists expect UK inflation to climb as lockdowns ease and consumers start spending again.
The US rate is exploding
Meanwhile, US investors are getting rather antsy about inflation — and with good reason. On Friday, we found that US core personal consumption expenditure (PCE) — which excludes volatile food and energy costs — hit 3.1% in April. That compares with 1.9% for March and an April forecast of 2.9%. It’s also the highest level of core PCE in almost 30 years (since 1992).
Clearly, US inflation is rising as the economy starts running hot. But the US central bank has indicated that it will not lift the federal funds rate above its current level of 0% to 0.25% for some time to come. This is because Fed officials believe that recent inflation spikes are temporary or transitory, caused by supply-chain congestion and trillions of dollars of fiscal stimulus. Still, investors fret about the downside risks of rising prices, hence recent declines in bond values and the sideways movement of stock markets.
I’ll keep buying cheap UK shares
What am I doing to prevent inflation from harming my wealth? First, my family portfolio includes no bonds (because I view prices as too high and yields too low). Second, if inflation does run rampant, then I won’t be too worried, because I’m increasing our exposure to cheap UK shares. What I’m looking for are companies with strong revenues, cash flows, earnings, and chunky cash dividends. For example, with several FTSE 100 giants offering yearly dividend yields of 6%+, I welcome this passive income as a valuable hedge against inflation. Third, I’m reducing our exposure to US stocks, whose high valuations make them more vulnerable to rising inflation. Finally, I’ll be closely watching the inflation figures throughout 2021!