In-depth Analysis

High inflation. What does that mean?

Over the last couple of days, we have had inflation data from both the UK and the USA  in each case the rates remain stubbornly high and they are climbing. 

What’s more, the headline measures of rates of inflation may not tell us the whole story.

UK CPI  inflation is calculated to be running at +7.0% per annum however the alternative RPI measure of UK inflation comes in at +9.0%.

Let’s assume an average rate of inflation of +8.0% per annum in the UK what does that mean? Well, firstly its means that prices are likely to be rising by that amount each year. However, it also means that the spending or purchasing power of the money in our pockets is diminished over time. 

£ Rate of Inflation Real value of £1000
Year 1 1000 -8.00% 920.00
Year 2 920.00 -8.00% 846.40
Year 3 846.40 -8.00% 778.69
Year 4 778.69 -8.00% 716.39
Year 5 716.39 -8.00% 659.08
Year 6 659.08 -8.00% 606.36
Year 7 606.36 -8.00% 557.85
Year 8 557.85 -8.00% 513.22
Year 9 513.22 -8.00% 472.16
Year 10 472.16 -8.00% 434.39

 

In the table above we look at the result of inflation on the effective spending power or real value of £1000, over a 10-year period when inflation is running at +8.0% 

If you are of a nervous disposition look away now.

By year ten the purchasing power of that £1000 has been reduced to £434.39 more than 50% of the value has been eroded by inflation.

Central banks are hoping (or is that clinging onto the notion?) that current levels of inflation are going to be transitory. However current economic conditions have several similarities to those of the 1970s when a phenomenon known as stagflation stalked the land. 

Stagflation is caused by supply-side shocks, in the 1970s it was caused by a sharp rise in energy prices. 

Would it surprise you to know that the price of Brent crude oil has risen by +226.0% over the last two years? Covid and more recently the war in Ukraine have played their part in driving oil prices higher and creating choke points in the global supply chain?

Stagflation struck in the UK during 1973/74  and the inflation it created hung around for far longer. 

UK inflation between 1970 and 1980

What does all this mean for traders?

In the financial markets, money is said to flow to where it can find the best return and with interest rates, at just +0.75% in the UK, at best, the real or inflation-adjusted return for holding sterling currently, is -6.25% which could hardly be thought of as being attractive. 

That can be seen in the recent weaknesses of the pound versus the US dollar and with the US Federal Reserve thought likely to start raising its interest rates by +0.50% increments from May, there is every chance that the pound may continue to lag, based purely on interest rate differentials.

GBPUSD 

It’s not all bad news for the UK however, because the FTSE 100 index is chock full of overseas earners. Companies that export their goods and services to markets outside of the UK. 

A weaker pound or lower exchange rate makes UK exports more attractive to overseas buyers. This means that FTSE 100 exporters can sell more and earn more for their shareholders. 

It’s interesting to note that the FTSE 100 is one of just a handful of major indices that are still up on the year to date, and out of 20 major equity indices that I follow it is the only one that is exhibiting strong bullish tendencies in my model.

 

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