Inside the UK’s Inflation Divergence

A raft of inflation data hit mid-week, and there was good news for Canada and the eurozone: The sharp inflation slowdown continued in March. On Tuesday, Statistics Canada reported the Consumer Price Index (CPI) clocked in at 4.3% y/y, extending the improvement from last June’s 8.1% peak.^[i] The eurozone’s final March estimate confirmed the flash reading at 6.9% y/y, continuing the trip down from October’s high of 10.6%.^[ii] But one nation’s readings remain stubbornly higher: UK March inflation remains lodged in double digits. Despite expectations of a drop to 9.8% y/y from 10.4%, it fell only half as much, hitting 10.1% in March—and down just one percentage point from October’s 11.1% peak. The path has also been more jagged, with a temporary reacceleration in February. Stubborn inflation has contributed to the UK’s particularly low sentiment. But there, too, improvement is on the horizon, which should help propel stocks up the wall of worry.

The UK’s inflation divergence stems largely from the country’s energy policy. In Canada and the US, energy prices are market-set, leading to rapid improvement on the consumer front as wholesale fuel and power prices fell. Several European nations subsidized energy at the provider level, keeping the full cost increases from filtering through to consumer prices. The UK did that too, to an extent, but it has also capped household energy prices since 2019.

That cap initially reset semiannually—every April and October—and it quickly became a price target. Accordingly, household energy costs have jumped in big stairstep increments every six months, and providers haven’t yet passed reduced wholesale costs to consumers. Further complicating matters, the government is paying the difference between its own price ceiling and the energy regulator’s cap, so households won’t start seeing a decline until the regulatory cap—currently at an average annual cost of £3,280—falls below the government’s £2,500 average annual cost ceiling … or until the government’s assistance expires in April 2024, whichever comes first.

The other item boosting UK inflation—and the one stealing most headlines Wednesday—is food. Foodflation hit 19.6% y/y in March, the highest rate since data begin in 1989.^[iii] That contrasts not only with the US, eurozone and Canada, where food price increases have started slowing, but also with global food commodity price indexes. Inevitably, headlines have pinned this on Brexit—arguing it limits import supply and raising shipping costs—and “greedflation,” which is a nasty-sounding term for the very normal practice of raising consumer prices, as and when demand allows, to preserve profit margins as costs rise. But in reality, the causes are more bland. One, UK supermarkets tend to lock in prices on long-term contracts. Hence, they are presently paying suppliers and farmers based on higher food commodity prices several months back. As those contracts reset at lower prices, it should translate to cheaper meat, egg, dairy, grain and sugar prices (and lower prices of all the processed foods containing those inputs). Two, there are some localized supply issues, including an avian flu outbreak that affected egg supply and bad regional weather affecting produce and sugar beet harvests. Three, industrial action has hampered transit of not just food, but packaging materials—another supply headache (not that we are passing any judgment on the strikes themselves).

All of these pressures should soon ease. Warmer weather has already led to an increase in local dairy production, as cows can once again graze happily. Falling global grain prices make livestock cheaper to feed. The avian flu emergency has largely passed, returning free-range eggs to supermarket shelves. Most food suppliers say the packaging cost pressures were a one-time thing and shouldn’t affect prices indefinitely. The much-discussed shortages of tomatoes and other fruit and veggies are also easing as the local growing season kicks off in earnest. Households should soon get some much-needed relief.

Once the food and energy kinks iron out, easing inflation should be much more apparent. The core inflation rate, which excludes food, energy, alcohol and tobacco, is much more in line with the rest of the developed world at 6.2% y/y.^[iv] As in other places, disinflationary monetary conditions should foster further improvement. Broad money supply growth, at 3.0% y/y in February, is back at mid-2010s rates.^[v] That, you may recall, is a period when everyone worried inflation was too slow. Even that 3.0% rate stems partly from base effects, as money supply has fallen in four of the past five months on a seasonally adjusted, month-over-month basis.^[vi] Loan growth is also now negative at -0.3% y/y in February.^[vii] It, too, is negative in four of the last five months on a seasonally adjusted basis.^[viii] This is an economic headwind, and it is one of the biggest reasons we remain on watch for a UK recession, but it also combats inflation. Couple tighter monetary conditions with marked global supply chain and shipping improvement, and we see strong potential for UK prices to ease.

Inflation doesn’t have a pre-set market impact, so we aren’t saying falling inflation is massively bullish in the UK or anywhere. But inflation did hit sentiment hard, which we think contributed to last year’s global bear market. So it stands to reason that easing inflation should help reduce uncertainty—especially as it helps ease rate hike jitters. It may happen in fits and starts and at uneven rates globally, as the UK has shown, but overall, easing global inflation should alleviate one of investors’ big worries. One less thing hanging over stocks.