Welcome to February; for some, their least favourite month of the year. Why? – it’s generally cold, dark and wet; the holiday season seems a long time ago and Spring is many weeks ahead. Some have “enjoyed” a ‘dry’ January, whilst others may have obsessed about healthy eating, to the point ‘ten fun food facts about avocados’ is all they seem to talk about. How can we cheer ourselves up? It’s worth remembering February has Pancake, World Nutella and Valentine’s Day; we have the glamour of the Oscars and – if you want to wear tropical fancy dress and drink a rum punch – why not celebrate Bob Marley Day and/or the Rio Carnival. If we shut our eyes, we can pretend it’s summer!
Talking of summer, a favoured antidote for February blues is commonly planning and booking a holiday. The feel good factor this creates, however, has no doubt been tainted for sterling-thinkers this year, given the sharp price rises we are facing for travel overseas. The pound is c.15% weaker, versus the US dollar, since the EU referendum; resulting in holidays becoming much more expensive. We appreciate this is a ‘discretionary’ spend, but there is no questioning the fall in the value of the currency is feeding through into inflation figures relatively quickly and also impacting the prices of those ‘staples’ we all have to buy. In December, inflation in the UK hit a 29-month high of 1.6%, as a result of rising food and fuel prices, alongside those air fares. Consensus forecasts have UK CPI rising above the 3% level through 2017, with expectations inflation will remain elevated in 2018.
Uncertainty around Brexit is likely to keep the pound under pressure and this could result in the UK suffering a period where inflation may be described as ‘sticky’. Understanding how households and the corporate sector react to this will be a key question for UK investors, as rising inflation expectations have profound asset allocation implications.
Source: SSGA, Bloomberg Finance L.P. forecasts, Citi Research
If we look at households first, we believe it is inevitable a moderation in consumer spending will be seen, or – more likely – a slowdown in consumption, as inflation erodes the ability to spend. We do not foresee inflation reaching the kind of levels – in excess of 9% - we saw in the early 1990s, but it will likely be high enough to impact consumer behaviour. Should inflation prove sticky, or if it rises higher than currently expected - pressure will build on the Bank of England to raise rates. This will be significant for those households with mortgages. Nine years of no rate rises in the UK have seen a new generation of borrowers who have never experienced a rate increase and have, perhaps, become complacently comfortable with such a cheap cost of borrowing. This group represents about 20% of all mortgage holders in the UK.
Higher interest rates will be a positive for retail banks on the income side, but the quality of their assets – mortgages and other loans – could deteriorate quickly. A Bank of England NMG Consulting survey highlighted 31% of UK mortgage holders would need to take action, such as cut spending, work longer hours or request a change to their mortgage, if interest rates rose by two percentage points and their income remained unchanged. The same survey also reported half of all borrowers, including those with credit card debt, would cut spending in response to a two per cent rise in rates. The impact would not be equally felt: the proportion of mortgage holders that are highly geared is double in London and the South East, compared to Scotland and Yorkshire.
In our view, the debt burden in the UK – both public and private - is too large to accommodate higher interest rates and a period of inflation, running above the official policy target of 2%, will be the near term outcome. In terms of the corporate sector, those with cash on their balance sheets may be encouraged to invest, be it in plant and machinery, new hires and/or M&A; although Brexit uncertainties may temper this. For others who borrow through the bond market, their funding costs will likely rise as the yield curve steepens.
Turning to the global inflation outlook
A recovery in the crude price and strengthening real wages has led markets to re-price inflationary expectations upwards. This, coupled with the potential impact of the Trump administration’s fiscal and trade policies, suggests we may have already entered the early stages of a US cyclical inflationary trend. In addition to the rise in oil, it is worth noting the Baltic Dry index (a measure of the costs for shipping various raw materials) has climbed sharply in recent months, as has the UN measure for global food prices. Despite this and the US aside, we still believe that debt and demographics mean deflation is the longer-term risk.
Returning to avocados
This weekend sees the New England Patriots square up to the Atlanta Falcons in the Super Bowl. Across the US, families and friends will gather to watch the game, during which it is estimated they will consume 13,000,000kg of chips (crisps), 1.25 billion chicken wings and 3,600,000kg of guacamole. The latter, of course, will require lots and lots of avocados. Mexican growers, having long since overtaken California producers, today supply c.90% of avocados sold in the US. If implemented, Trump’s policy for funding ‘the wall’ - namely a 20% tax on Mexican imports - will result in avocado inflation for next year’s Super Bowl. Holy guacamole!
Julia Warrander and Russell Waite
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