Forget deflation or inflation – this is the year of noflation
Kames Capital’s chief investment officer Stephen Jones outlines his current thoughts on the UK inflation environment.
The UK’s official inflation rate stayed at 0% in March, unchanged from February’s reading, with falls in clothing and gas prices countering a rise in petrol and food.
The figure looks fairly startling to most of us because not only is it the lowest level since records began some 26 years ago, but also because there is now a growing fear of deflation, something central banks do not know how to tackle efficiently.
In the near term it seems almost certain that we sink into negative territory as far as the headline number is concerned, possibly as early as next month’s reading.
For some investors, a sustained period of deflation is mixed news. Many equities would suffer as companies saw revenues fall back as consumers delay purchases, while anything paying an income would thrive as coupons become even more attractive.
However, ultimately because economies need consumption to grow, any sign consumers are holding back on purchases because of an expected fall in the price of goods would be a headwind for the economy.
It is this outcome that has caused central banks to pour hundreds of billions of pounds, dollars, yen and, most recently, euros into markets to offset a deflationary spiral. Now, of course, they also have to account for the effects of the plunge in oil prices which, while positive for economic growth, nonetheless puts CPI figures under yet more downward pressure.
Oil is certainly seen as a game-changer for the UK, providing a boost to consumers used to much higher petrol prices, while also feeding into the cost of other goods. But on the other hand, it also makes a period of falling prices more likely.
The big question now is how long does the oil price stay low (and therefore keep having a negative impact on inflation). At present the supply/demand dynamics still look unfavourable for oil, with supply in the US hitting a 30-year high in December of 9.15m barrels per day, and prompting the US Energy Information Administration to predict supply would outstrip demand in 2015.
Does this oversupply mean oil heads back to $40 a barrel? We don’t think so, but equally the era of $100 a barrel or above seems unlikely to re-emerge for at least 18 months.
For investors the issue is whether this low oil price environment pushes the UK into deflation, but that is not our base case. Just as a lack of wage pressure in the system will keep a lid on price rises, the downside is capped by the huge amount of stimulus being pumped in, and while we might see the odd negative print from the Office for National Statistics, the outcome we actually expect this year is noflation.
The Bank will continue to do whatever it can to avoid deflation, with a further cut to the base rate even being mooted by one member of the MPC, while it has also made it clear it would act to raise rates if needed (although this option looks far less likely with inflation at 0%).
So rather than seeing the spectre of deflation, we expect the current situation to remain for some time, with equities and bonds both strongly supported at these levels, and with the potential to rally further. After all, policy should remain uber-loose because of the lack of inflation, and that leaves asset markets looking attractive for most investors, particularly those seeking an income.