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UK equity income funds brace for inflation spike

UK equity income funds brace for inflation spike

A sharp rise in inflation could force UK equity income managers to reposition sector exposures as expectations for a prolonged period of higher prices but depressed wage growth take hold.

The UK consumer prices index measure hit a 22-month high of 1 per cent in September, up from 0.6 per cent in August, despite the Office for National Statistics suggesting the impact of a weakened sterling is yet to be felt. Expectations for 2017 inflation levels range from 3 to 5 per cent.

Fidelity investment director Matthew Jennings said the anticipation of a shift from a deflationary to an inflationary environment would result in a “significant re-rating of sectors”.

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“There’s been a strong consensus over the [past few] years that we’re not likely to see any significant inflation and, therefore, we’re not likely to see any rise in interest rates or bond yields. This has allowed a significant rating of sectors such as consumer staples and tobacco, which have become known as the ‘bond proxies’,” he explained.

Peter Toogood, investment director at The Adviser Centre, warned a change to this trend would cause problems for all UK equity income funds. He said these portfolios would not be able to withstand an inflation spike.

This consequence will be especially pronounced if higher inflation is not accompanied by wage growth. “Simply put, it’s everything staples, everything that’s been the darling of the past six years will come under pressure,” Mr Toogood said.

“In the short term, the immediate reaction is probably to sell the bond proxies off. They will struggle. Tobacco stocks, pharmaceuticals to a degree, certainly staples. They’re all in that bucket and they’re all expensive.”

A notable proportion of UK equity managers could be affected. According to FE Analytics, 36 funds in the IA UK All Companies and UK Equity Income sectors hold more than 10 per cent in relevant consumer discretionary stocks, while 38 funds have similar amounts in consumer staples.

“It’s not going to be [income funds’] fault, they can’t avoid it. To generate yield you have to own parts of the market that are yielding. [Income] funds will be the most exposed. They’ll all struggle because it’s a generalised problem,” Mr Toogood added.

Signs of a wider shift in mood are already emerging in global investment flows, according to figures from Bank of America Merrill Lynch. Real estate investment trusts, themselves often seen as bond proxies, saw their largest outflows for 13 months last week. 

Mark Wharrier, co-manager of the BlackRock UK Income fund, warned the type of inflation set to emerge would be negative for many stocks, and said he was focusing on companies that have the ability to absorb price increases.

“Inflation is typically good for equities but it tends to be good if it’s reflation. We’re talking about increases in costs, which are going to put pressure on profits, so identifying companies with pricing power is crucial.”