Navigating UK inflation

The UK’s Office for National Statistics (ONS) released their monthly inflation report this morning. In spite of April’s numbers showing a marked decrease in most inflation measures, it is fair to say that the report was significantly worse than expectations. Headline inflation came in at 2.3%, down from 3.2% last month, while core inflation declined from 4.2% to 3.9%. However, Bloomberg consensus was 2.1% and 3.6%, respectively.

Looking at the headline number in more detail, it becomes apparent that there are a few interesting trends amongst the subcomponents, some of which are also present in other geographies. Firstly, the electricity, gas and other fuels component remains one of the disinflationary process’ driving forces. After the painful adjustments in 2022 and early 2023, this category has been in deflation mode since mid-2023. In April, the deflationary trend became more acute with year-on-year inflation of -27.1% compared to -18.2% in March. Secondly, core goods (that is excluding energy and food) disinflation is still helping the headline number. Core goods account for 29% of the Consumer Price Index (CPI) basket and all subcomponents showed lower year-on-year inflation than in the previous month. These include clothing, household goods, medical products and recreational goods amongst others. Overall core goods inflation came in at 0.6% year-on-year, which compares favourably with the 1.5% figure last month. As we have argued in the previous blogs, goods disinflation seems to be in its final stages, so it is imperative that services show more encouraging trends.

Sadly, services inflation seems unwilling to play ball just yet. On a year-on-year basis, services inflation declined by a pale 0.1%, from 6.0% to 5.9% in April. If we look at the three-month moving average, this actually increased. The trends were widespread within the services component and there is little indication that a large move downwards is forthcoming. Wages play an important role in the cost structures of services companies and a lot more progress in this area is needed in order to see a strong decline in services inflation, in our opinion.

We already felt that the Bank of England (BoE) was sounding slightly too optimistic and too eager to start cutting rates, even before April’s CPI number. Now, we can only be more convinced than before that the BoE just does not have good enough data to embark in the rate cutting process. Traders seem to agree, judging by the moves in the gilt market and in the implied probability of a June cut. For the remainder of 2024, the implied number of cuts moved from just over two to just over 1.5, a big adjustment indeed. We also note that even after today’s adjustment, markets are expecting an earlier cut from the BoE than from the Federal Reserve (Fed) with the first move by Bailey expected in August whereas Powell’s move is forecasted to occur in September.

Our take is that volatility in the curve, similar to US Treasuries, will continue until it becomes clearer that the BoE actually has the data they need at hand to start relaxing monetary policy. From a portfolio construction point of view, we believe this upside surprise in inflation highlights that the best strategy for a fixed income portfolio at this juncture is to not bet on outsized rallies in government bonds. Given current valuations and the degree of curve inversion, those capital gains are only likely if they are accompanied by some sort of a hard landing in the economy. With the UK economy recovering at the margin and slightly better growth expected going forward, chances of a hard landing in the short term have actually decreased, which increases our confidence in that betting on large capital gains from government bonds is not the right strategy. Credit should continue to outperform in this scenario, even if spreads in certain parts of the market do not look cheap, as carry is likely to be the major contributor to total returns. Just like in the old days!