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April falls: inflation and sterling down but cash threat remains

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Summary

We think falling inflation is good for the UK economy and expect sterling to recover from this week’s drop.

3 min read

Last week’s fall in inflation to 2.5% from 2.7%, according to the Office for National Statistics, defied market expectations for it to stick where it was.

Sterling slid by 0.74% against the dollar as expectations for a Bank of England (BoE) rate rise next month took a hit.

BoE governor Mark Carney cast further doubt on a rise by taking a dovish tone in an interview with the BBC on Thursday night. He referred to weaker elements of the economy such as current low retail sales as reasons to “sit down calmly and look at it all in the round”. Sterling fell further following his comments.
 

Keep calm and carry on

We believe inflation has passed its peak and will now gradually fall closer to the BoE’s 2% target. This shouldn’t alarm investors – 2% inflation is sufficient to support economic growth without putting undue pressure on the central bank to suddenly introduce potentially destabilising rises.

There are a number of reasons why the BoE might still press ahead with a rate rise next month – to 0.75% from 0.5%. Slow but steady growth remains in place and domestic inflationary pressures are on the up. Wages growth is above the rate of inflation, giving UK workers their first real-terms pay rise since 2014, and employment is at its highest since the 1970s.

This should be good for the UK economy as people have more cash in their pockets. Retailers have borne the brunt of the decline in real incomes and this should provide some relief.

The BoE is also likely to want some ‘wiggle room’ to lower rates again should the tide turn. The current very low levels make it hard for them to make adjustments in future.

 

“On the whole, while there are still causes for concern about the UK economy, the inflation fall provides further reason for cautious optimism about UK equities.”

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A sterling effort

Our long-term view on sterling remains positive as we believe it will continue to rise in value relative to other currencies over time. Brexit negotiations are making progress, UK stocks are reasonably attractively priced and we see overseas interest in UK commercial property – all of which benefit the currency.

Last week’s contest between Japan’s Takeda and Allergan in the US for UK-listed pharmaceuticals firm Shire, shows that sterling assets are attractive to overseas buyers. They’re perceived as offering good value and the potential for further gain as the currency improves.

We saw an opportunity to increase our sterling exposure two years ago when the pound fell as we felt markets over-reacted and the currency represented good value. We believed it would return to its long-term valuation and positioned our portfolios accordingly. As sterling has strengthened since, our investments have benefitted.

 

No harm done

There are no other signs of the inflation drop negatively impacting markets. It shouldn’t hurt UK equities which continue to benefit from global and domestic economic growth. In fact, the FTSE 100 rose following the news as its globally-focused companies benefitted from the drop in sterling. We recently increased our exposure to the FTSE 100 after February’s market falls which provided a further boost to our portfolios.

It is possible that gilt prices will rise as investors see a rate hike next month as less likely. We have held a low allocation to gilts for some time and retain this for now.

On the whole, while there are still causes for concern about the UK economy, the inflation fall provides further reason for cautious optimism about UK equities.
 

Don’t be fooled by falling inflation

Inflation may be falling but it remains a real threat to the spending power of your wealth.

It’s important to think carefully about how you preserve your wealth for the future, or even the next generation, and historically equities have been the only major asset class to outpace inflation.

There are risks – the value of investments can go down as well as up – but over the long term investing has been shown to lead to greater returns than a savings account. And that will remain the case no matter how much inflation falls.
 

Past performance should not be taken as a guide to future performance. The value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment.

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