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Inflation a headache for Bank - but boon for shares?

Ed Monk

Ed Monk - Fidelity Personal Investing

New inflation data this morning confirmed that price rises have continued to slow down, signalling some relief on household budgets but also providing evidence of a stalling UK economy.

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The Consumer Price Index (CPI), which measures the cost of typical UK household purchases, rose by 1.3% in the year to December 2019 according to the Office for National Statistics. The CPIH measure - which includes housing costs - rose by 1.4%. That’s the lowest since 2016 and continues a path of slowing price rises that began last summer.

Let’s deal with the good news first. Lower price rises mean people are getting richer in real terms, as long as wage income is rising by more. And it has been. We’ll get an update on wages next week but the last reading for October showed wages rising by 3.4%. That means wages are rising 2% in real terms.

There are important caveats. First, wage rises are themselves beginning to slow down, they were rising 3.9% last July, so real term gains may fall from here. Second, the real term wage rises we are now seeing only make up ground lost in the years after the financial crisis. In fact wages are still lower now in real terms than they were in 2007.

Yet the fact they are rising now means individuals and families should be feeling more positive about their circumstances.

This fact was perhaps underestimated in the recent General Election. It’s certainly possible to points to parts of the economy that are malfunctioning - poor job security and wage inequality mean many are still suffering hardship, while the UK’s struggling high streets are an all-too visible sign of problems. But when asked to alter course and opt for the radical change offered by Labour, with wages rising and unemployment low, voters declined.

The more negative side of lower inflation is that it signals less economic activity, and therefore slower growth in the economy. Prices rise more quickly when businesses think their customers are able and willing to pay the extra cost. The fact that inflation is falling suggests businesses are struggling to maintain sales.

This is why the Bank of England has a target of 2% inflation - that’s seen as a healthy position where the economy can expand but not too quickly. With inflation now as low as 1.3%, the Bank may act to stimulate growth with a cut to interest rates as soon as this month.

For investors, the upshot of that could be yet more fuel for stock markets, which in many regions are already near record levels. Despite a rate cut being made to remedy a slowing economy - which you’d think would be negative for shares - there can be a shorter-term boost to share prices because the market recognises that trading conditions are about to get easier, via lower borrowing costs for business and individuals.

Rate cuts also make the yield on cash, and near-cash assets like government bonds, less attractive. In turn, this makes the potential return from shares more attractive, so demand goes up.

In that scenario, it can be funds buying the shares of the largest companies paying big dividends that prosper. Our Select 50 list of favourite funds includes many UK focused funds looking for high and sustainable dividends.

Franklin UK Equity Income, managed by Colin Morton, follows such an approach. Liontrust UK Growth, also targets the largest UK growth companies.

Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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