Inflation Pressure Builds

Posted on: 26 June 2008 by Gareth Hargreaves

The week's money and market news with finance expert Graham Kerner.

Inflationary pressures continue to build globally and mean that higher, rather than lower interest rates are possible. Bank of England governor Mervyn King said that the economy will slow further but that inflation would not be allowed to become ingrained although the Bank denied that a rate increase was a certainty. Oil prices were volatile and once again hit a record high. Gordon Brown attended a meeting with Opec and other Western politicians to seek increased output to help supply issues.

Credit and equity markets were under pressure last week with poor earnings figures from Morgan Stanley upsetting investors. The fashion for owning commodity investments may be over - private investors are switching out of the sector. Pension planning should stay on people's agenda, as the tax breaks are still very attractive.

Inflated Expectations

Most of us will not need telling that inflation - benign for so many years - is back with a vengeance and likely to stay with us a while. Last week we learnt that annual CPI inflation hit 3.3% in May and way above the 2% target set for the Bank of England (BoE).

As The Sunday Telegraph pointed out, oil prices averaged $75 per barrel last year - so far this year the average is $108pb and last week oil hit another record high of $139.89pb, suggesting that the related rises in gas and electricity prices mean more inflation to come.

Of course one needs to put current events into perspective, and The Times argued that 30 years ago inflation was 25% and 20 years ago it was 10%, so today's levels are mild in comparison.

However, as The Daily Telegraph was quick to point out, the official CPI figures exclude fuel, mortgage and council tax costs which are a heavy cost to many and, by including these expenses, the paper calculated that the real cost of living index is nearer 9.5%.

It's not just higher energy costs which are a problem, food inflation is rising too, as The Financial Times discussed. The paper said that the rise in farmers' costs are feeding through to the supermarket checkouts, with inflation in the dairy sector well into double figures and with milk production falling in the UK, industry leaders are concerned about the impact of the increased demand currently being witnessed.

Yet it's not just the West which is suffering - inflation in the Far East and particularly China is worrying politicians. Last week, China unveiled subsidies for fuel users in an effort to prevent unrest and soften the blow of large increases in energy prices that were announced last week. Having held retail fuel prices steady since last November, the government announced a 17% price rise for petrol - it costs the equivalent of $0.85 a litre in China compared to $2.33 in the UK.

India too is suffering, with rising energy costs pushing the country's inflation rate to 11.05% - a thirteen year high. According to The Financial Times, the latest figure is double the “comfort level” set by the central bank of less than 5.5%. With elections expected before May, the government needs to bring inflation under control but this could, said the paper, hurt growth prospects.

Oil On Troubled Waters

So with inflation clearly at the fore and high oil prices seen as the single largest contributor, Gordon Brown headed for crisis talks in Jeddah where an emergency meeting of oil producers and consumers was being held. The summit is expected to see politicians exerting pressure on Opec to increase output to ease the strain on global supply.

Ahead of the meeting Saudi Arabia, the world's largest producer, announced it will raise output by 2% next month (equivalent to 200,000 barrels a day) although, as The Daily Telegraph pointed out, the country produces ‘heavy' crude oil as opposed to ‘sweet' crude which is in greater demand.

Whilst agreement may be reached, the overall situation was not helped on Thursday with news that Nigerian militants blew up a Chevron pipeline which halted shipment of 120,000 barrels a day.

Not to miss an opportunity, the Prime Minister is likely to ask oil rich states such as Saudi Arabia to invest in the next generation of British nuclear power stations and, in exchange, Britain and other Western economies should open up their economies to sovereign wealth funds.

Challenging Times

Last week the governor of the BoE Mervyn King used his annual Mansion House speech to City grandees to predict that, "The squeeze on real income growth is likely to mean that both house prices and consumer spending will weaken together."

The Chancellor, also present, conceded that his budget forecasts would not be met, accepting that inflation would be higher than predicted.

Mr. King also made it clear that he would not allow higher pay deals to result in ingrained inflation - a clear hint that the Bank would raise interest rates if necessary, thought The Financial Times. Fears of higher rates were raised following the publication of the minutes of the last MPC meeting and sent money markets on a rollercoaster ride.

However, according to The Sunday Times, in an effort to calm nerves, sources close to the Bank said the message on interest rates was intended to be neutral and not taken as a signal that the BoE was contemplating raising rates.

It was not only the credit and money markets that had a volatile week - global stock markets also found the going tough with traders upset by news from Morgan Stanley that its earnings had fallen sharply in the last quarter. As a consequence, fresh concerns about the outlook for the global banking sector surfaced, undermining investors' confidence and so unsurprisingly, banking stocks were in the limelight with prices falling across the board.

In the UK there was more evidence that retail sales are still under pressure with stay-at-home consumers denting sales at John Lewis.

However the beleaguered house building sector enjoyed a fillip on the back of news, reported by The Times, that Barratt Developments had reached a deal with its banks to put its finances on a firmer footing: the company's shares jumped 25%.

By the close of business on Friday, most major equity markets had given ground, although Tokyo displayed remarkable resilience with the Nikkei 225 index ending virtually unchanged as investors took a more sanguine view of the outlook for Japanese companies.

Staying Ahead

With all the talk of inflation, The Sunday Times posed the question “Can you inflation-proof your finances?” From an investment perspective equities have, in the past, been a good way to protect capital against inflation over the long term. The paper commented that a well-diversified portfolio of equity funds remains a good hedge against inflation - dividends have historically risen faster than inflation and re-invested, account for the lion's share of total returns from equities. Readers were reminded that equity income funds have long been a favourite - aiming to deliver a dividend stream 10% higher than the FTSE100 average while also aiming for capital growth. Over the last five years some of the best-performing funds have doubled investors' money.

One sector that has become the darling of investors is commodities, where prices have risen several fold in the last two to three years. However it seems, according to The Financial Times, that investors are calling time, despite continuing record prices - some £1.2bn left the sector last month.

Any falls in commodity related stocks could have a big impact for investors, according to The Sunday Times - mining, oil and gas companies now account for an astonishing 50% of the FTSE100's capitalisation, with seven out of the top ten stocks either mining or energy related companies. The paper said it was very reminiscent of the technology bubble, when high-tech and telecom stocks accounted for 35% of the market by value.

Fund manager John Hodson of THS Partners comments, "We have been reducing our holdings in the mining sector - I think growth will slow in China in the months ahead and demand for many commodities will be affected."

Double Your Money

It's always useful to be reminded about the basics and The Sunday Times in an article about the change in pension rules - the minimum age to take cash from a pension rises to 55 in 2010, highlighting the need for planning now - also showed its readers how to get a 114% return on their pension.

If a higher rate taxpayer puts £80,000 into a pension it is grossed up to £100,000 and one can claim a further £20,000 tax relief.

At age 50, 25% can be taken as tax-free cash leaving £75,000 in the pension for a net outlay of just £35,000 - a return of 114%.

Remember, you do not have to buy an annuity until 75 as the fund can remain invested in a portfolio of shares or collective investments.

Exciting Times

Probably not how most would describe stock market behaviour in recent months, but for UK equity income manager Nick Purves of Schroders, who manages funds for St. James's Place, recent events have created some extraordinary opportunity.

"On the face of it the market feels pretty sick with investors in a nervous state of mind, concerned about the outlook for the US and UK economies, with the companies most exposed having been hit hard. Commodity prices are still strong which is feeding higher inflation and restricting central banks' ability to cut interest rates. So the markets are worried about slowing growth."

"It is very important to separate-out the outlook for the economy - which I agree looks poor - from that of share prices: these are very different things. A huge amount of bad news has already been priced into current share prices, for example, banks, house builders and other consumer related sectors are down 50% or more. So one needs to be clear about firstly the economic outlook and, on the other hand, stock market values."

"You may be surprised, but actually the message is very positive. Firstly the portfolios have very little exposure to the vulnerable sectors mentioned and in fact, after months of relatively little activity, I am now aggressively putting money into these areas. Of course, I read the papers and see the same gloomy news, but when owning equities one needs to relate everything back to value."

"You need to remember that when valuing a share you are looking at the return of an investment, in cash-flow terms, over a fifteen year period. The market is obsessed with the short-term, mainly down to hedge funds, and is only focusing on the next twelve months which makes up a small proportion of a company's long-term value. The question I have to ask is whether it's just next year that is going to be difficult or whether a company's value is permanently impaired."

"These are pretty exciting times because the market is too pessimistic and the best investment returns are made when sentiment is poor. So we've been buying companies like Lloyds TSB which yields over 10%, and Daily Mail Trust which trades on a p/e of just six which is ridiculously low - in fact, there are many good companies that yield 6-7% and trade on similar p/e ratios. Hedge funds and their ilk are very short-term and will smash up anything which disappoints or may disappoint in the immediate term. Fortunately this provides wonderful opportunity for medium term investors like myself and market undervaluation is now widespread. So right now I own thirty or so stocks, the yield on the portfolio is over 5% and I'm positive looking ahead. I don't know where the market might be over the next six months, but I'm very confident that over the next 3 to 5 years there is great value to come."

23rd June 2008

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