Put UK Inflation and Rate Fears in Proper Perspective

Did the Bank of England (BoE) just overreact to hot videogame sales? That is one potential interpretation of Thursday’s half-point rate hike, which policymakers pinned on May’s surprise inflation reacceleration … which derived in part from gangbusters demand for the new Legend of Zelda game lifting recreation and culture prices. But instead BoE head Andrew Bailey once again blamed workers’ seeking higher wages and companies’ protecting profit margins for driving prices higher, fueling the belief that the UK’s inflationary pressures are somehow different and stronger than the rest of the world—and potentially necessitating rates to rise from today’s 5.0% to 6.0% or more by year end. With this comes a feared mortgage squeeze compounding cost-of-living pressures, potentially ratcheting up recession risk. Yet for UK stocks, which flirted with correction territory (when measured in GBP) this spring, none of this is surprising, new news. These factors have been discussed, debated and dissected in headlines for months. Rather, it seems like a classic case of the UK zagging on sentiment while the rest of the world zigs. Divergences like this usually don’t last for long, and with fundamentals globally looking pretty good, the stage seems set for UK stocks to rebound much faster than people seem to expect.

The popular view of the UK economy now is that with the headline consumer price index including owner occupiers’ housing costs (CPI-H) accelerating from 7.8% y/y to 7.9%—and core inflation speeding to a fresh high of 6.5%—the BoE hasn’t yet put a lid on prices.^[i] That means more rate hikes at a time GDP growth is mostly wobbling sideways, making recession a foregone conclusion as more mortgages come off their fixed-rate periods, exposing more and more borrowers to a sudden surge in monthly payments. Pair higher housing costs with the too-slow march to lower energy prices (tied to the government’s dueling price caps) and stealth tax hikes, and there isn’t much left over for discretionary spending and investment.

That, at any rate, is the going narrative. Stocks might seem to reflect this, too, at least to an extent. The MSCI UK Investible Market Index (IMI) is down -4.6% from its last all-time high on February 16.^[ii]

But here are some counterpoints. One, consider CPI-H’s owners’ equivalent rent. That is the same made-up cost that has been artificially inflating US CPI lately, and it is the primary culprit driving UK CPI-H higher last month.^[iii] The UK’s legacy CPI, which most headlines focus on, excludes this line item and, as a result, its 8.7% y/y inflation rate was unchanged from April. As for the rest, food prices decelerated markedly, but hardly anyone noticed because the big acceleration in recreation and culture prices offset it. The ONS pinned this on “computer games,” which points the finger squarely at Zelda. In the same way a Beyoncé concert caused a one-off inflation surge in Sweden last month, a big cultural event can skew inflation data as prices respond to the temporary demand. It can be jarring in the moment, but it doesn’t last. Meanwhile, producer prices are down near a zero percent inflation rate, and broad money supply has spent five of the past seven months in contraction. So the stage appears set for inflation to keep easing regardless of BoE hikes.

As for the alleged mortgage time bomb, it is true that UK homeowners are more exposed to rate hikes than their US counterparts. Where the 30-year fixed is king of the mortgage mountain in the US, most UK mortgages are fixed for their first few years, then floating thereafter. So there is a not-small contingent of people who bought homes at historically low rates a few years back and now face monthly payments tied to rates around 6 or 7%, depending on the terms. However, penciling in perma-pain rests on presuming the BoE will keep rates high indefinitely. The massing disinflationary forces argue against this, as does the ever-present recession watch. We could be looking at a very different interest rate environment a year from now. Then, too, every borrower’s situation is unique. Homeowners who have built equity thanks to surging home prices in recent years may have underappreciated refinancing flexibility. So we are darned skeptical of all the talk about surging mortgage rates wiping out disposable income. You can hit a speed bump without crashing, especially if signs have warned of that speed bump miles and miles ahead of it. People are darned adaptive when they see an issue and have time.

We aren’t arguing good news abounds in the UK economy. It is muddling through and battling headwinds, even with the recent consumer spending upturn. But stocks don’t need steadily good news. Reality outpacing expectations is generally enough, and expectations are extremely low right now. The good cheer that accompanied the recent upward revisions in the BoE’s and other outlets’ GDP forecasts? Vanished, replaced by inflation doom and rate hike gloom. Everyone focuses on wage/price spiral chatter (despite this theory being debunked by Milton Friedman decades ago), while very few acknowledge the disinflationary monetary conditions. And absent seasonally adjusted month-over-month price data, it is too hard for most observers to disentangle base effects from fresh monthly wiggles, so it may be a while still before slowing inflation becomes more visible to the masses. But there does seem to be a growing gap between sentiment and reality.

Therefore, to us, UK stocks’ decline looks sentiment-driven. The economy may have its problems, but growing global demand has a habit of pulling weaker countries along, and the UK looks primed to receive a tow from the US, Asia and other growing areas. So while UK stocks may be registering people’s feelings lately, they should have some decent fundamentals to weigh once fear gets more fully priced in. Global stocks should also help tow UK stocks. The correlation coefficient between the UK and the rest of the world is 0.86.^[iv] Considering -1 means two variables always move in opposite directions, 0 means no relationship and 1 means they move in lockstep, a 0.86 correlation means they move together the vast majority of the time. That makes the past couple months’ divergence a very strange, unusual phenomenon—unlikely to last.

The relationship would be restored if global stocks started falling alongside UK markets, but that seems improbable to us. US stocks are climbing a big wall of worry right now, with false fears aplenty keeping sentiment low while better-than-expected economic results and gridlock in Congress help stocks climb. Those positive forces aren’t going anywhere, making it more likely that UK stocks eventually resume climbing alongside the rest of the world. The turning point is impossible to pinpoint, but looking 3 – 30 months out—as markets do—we think UK stocks are much likelier to be up than down. Maybe not up as much as the rest of the world’s, given the UK’s higher commodities weighting and relative dearth of quality growth stocks, but up.

Successful investing is often about looking past fearful headlines and weighing probabilities. When headlines are chock full of bad news, it helps to remember that markets see it too and, over time, will move on the gap between the sentiment those headlines create and how reality actually shapes up. Perfection is neither mandatory nor possible. If the UK merely does less bad than expected, that should be enough for markets.