With inflation expected to reach 3.0% by the end of the year, some UK-focused companies may struggle as consumers become more cautious about spending.
A weaker pound following last June’s Brexit vote has pushed inflation higher with the UK consumer price index (CPI) now sitting above the Bank of England’s 2.0% target.
CPI held at 2.3% year-on-year last month, according to the Office for National Statistics, as increases in clothing and food prices were offset by a decline in airfares due to the timing of Easter.
Martin Beck, senior economic advisor to the EY ITEM Club, expects inflation to exceed 3% during the summer.
“It is looking increasingly likely that the CPI measure will breach the 3% barrier during the summer, triggering a letter of explanation from (BoE Governor) Mark Carney to the Chancellor," he said.
British-focused retailers are among the worst affected as it becomes more difficult to past on rising import costs to consumers given fierce competition within the sector.
Consumers have started to be more frugal with their spending on non-essential items such as clothing, which has hurt UK fashion retailers such as Next Plc (LON:NXT).
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Next reported its first decline in annual profits for eight years last month, blaming a shift in consumer spending habits due to increasing inflation.
'Shrinkflation'...
Within the consumer goods sector, so-called ‘shrinkflation’ – whereby companies reduce the size of their products but keep the price the same – has affected the likes of Doritos, Toblerone, Maltesers and Coco Pops.
The problem arguably started with Unilever plc (LON:ULVR) following a row with Tesco plc (LON:TSCO) over the price of Marmite last year.
Unilever wanted Tesco to raise the price of Marmite to offset an increase in inflation but the supermarket didn’t want to deter its customers. UK supermarkets had been engaged in a pricing war at the time amid tough competition from smaller discounters, including Aldi and Lidl.
Adrian Lowcock, investment director at Architas, said ‘shrinkflation’ was becoming more common practice given the pressure on consumer goods companies to keep prices low.
Where to invest…
Given the prospect of growing inflation as the UK’s formal exit from the European Union gets underway, Lowcock believes the stocks most protected from these risks will be those with the most pricing power.
Stocks such as pharmaceuticals, utilities and healthcare - which provide products and services that consumers rely upon - are most likely to weather any possible impact of rising inflation, he said.
Tobacco, an item which consumers are prepared to pay high prices for to fuel their addictions, will also be shielded from inflation.
Lowcock cautioned on supposedly low risk assets such as bonds as most of the pound's weakness and its impact on inflation have already been priced in.
“Bond yields have already risen in anticipation of rising inflation so investors need to look further afield,” he said.
He added that property, also a popular choice as a hedge against inflation, is still a good investment given low borrowing costs and interest from overseas buyers looking to take advantage of a weaker sterling. That is provided the economy holds up after Brexit, he said.
Real estate companies that rent out warehouse space have growth potential, he said, boosted by demand from the likes of Amazon, which has been expanding its business across Europe.
The analyst expects inflation to peak at 3% before levelling off next year.
Inflation rises but BoE to keep rates low
The central bank kept interest rates unchanged at 0.25% last month amid the uncertainty of Brexit.
However, policymaker Kristin Forbes expressed concern about rising inflation and voted to raise rates.
While Forbes is stepping down at the end of June, Carney has previously said there was a limit to how far the central bank could tolerate inflation overshooting its target.
Howard Archer, chief UK and European economist at IHS Global Insight, said it was becoming evident that the Bank has become more worried about inflation edging too high.
“However, we suspect that any Bank of England temptation to raise interest rates will be tempered by mounting evidence of a slowing UK economy as consumers rein in their spending and business caution mounts,” he said.
“We maintain the view that the Bank of England will keep interest rates at 0.25% through 2017 and 2018 - and very possibly beyond.”
Keeping interest rates low would benefit housebuilders and real estate stocks, Lowcock said. It could have the opposite effect on banks as lower interest rates carve into profits.