S&W’s Wells: Further slump in sterling could keep inflation above target for a protracted period

Thomas Wells, manager of the Smith & Williamson Global Inflation-Linked Bond Fund which was launched a year ago, looks at sterling and the risk it poses to inflation expectations in the UK.

Two important things have happened in fixed income markets over the past couple of weeks: first, benchmark US, UK and German 10-year government bonds have rallied hard as risk has re-emerged in peripheral European sovereign markets, due to the political crisis in Italy.  Second, sterling has been absolutely smashed, retreating from $1.4325 on the 16 April to just $1.3308 at 31 May.

Sterling’s performance in the last month shows that FX remains the most fickle and most sentiment driven of all the markets. The pound has been hit by poor GDP data (which appears to have been worsening even before the ‘Beast from the East’ struck), a political fiasco (Amber Rudd’s departure strengthens the position of Tories pushing for a ‘hard’ Brexit with no customs union deal) and most critically, the rapid repricing of sterling interest rate futures (i.e. changes in market expectations of interest rates).

With the likelihood of a rate rise more or less removed for the foreseeable future, investors need to consider the implications for inflation.

Sterling’s decline, if it continues, poses renewed upside risks to CPI in the short term, and could see it not just hold at its current rate of 2.4%, but start to creep higher.

To be clear, we would need to see further material falls in sterling for the impact to be significant, and if the currency can stabilise at current levels then the overall inflation trajectory for the UK in 2018 is still better than it was in 2017.

But if the decline is not halted, there is definitely a risk that recent falls in inflation not only peter out but reverse. This would be particularly true if other factors – including oil prices at multi-year highs and the unknown implications from what is increasingly looking like a messy Brexit divorce from Europe – start to send it in the other direction.

How much could a weaker pound boost CPI? It is a constantly changing scenario, but if sterling fell another 10% on a trade-weighted basis and remained weak, it could add just under two percentage points to the headline inflation rate when measured on a year-on-year basis.

How should investors position for such a scenario? Potentially the most sensible way of hedging inflation is to diversify globally, rather than just being exposed to one market – like the UK – that could be hit by the country-specific concerns that we’ve outlined above.

For a sterling investor, there is also the option of investing in a dollar (as opposed to GBP) share class. This could provide an additional performance kicker in the event that sterling’s recent rout turns into something a little more significant.