UK Equities Reach Inflation Tipping Point

As UK inflation surges ahead, equity investors should be concerned. With yields on inflation-linked bonds at extreme lows, we think real assets offer a better way to combat the risk of rising prices.

The recent release of the UK Consumer Price Index (CPI) showed prices rising 2.7% year over year in January. It marked the 38th consecutive month of inflation exceeding the Bank of England’s 2% target. Current levels of actual inflation are not a huge problem for the UK equity market. Rising inflation expectations, on the other hand, pose a major risk.

For the last 20 years—and especially since the financial crisis—rising inflation expectations generally coincided with rising equity prices in the UK. This positive correlation may have lulled investors into thinking equities provide a good hedge against inflation. They do not. 

Rising inflation expectations coincide with rising equity prices only up to a point. In low inflation environments, rising expectations equate to economic recovery expectations. However, in normal or above-normal inflation environments rising expectations equate to overheating and/or rate hike expectations. In the UK, the inflection point between “low” and “normal” inflation environments appears to be around 3% on the break-even inflation (BEI) rate, which is derived by subtracting real yields from nominal five-year gilt yields. In mid-February the BEI rate broke decisively above 3%. 

The display above shows the “inflation beta” of the FTSE 100 Index for different ranges of five-year BEIs since 1985. The inflation beta simply tells us how much equity returns were helped or hurt on average by a 100 basis point rise in the five-year BEI rate. When the BEI is below 3%, the beta was positive, meaning rising inflation expectations helped equity returns. When the BEI is above 3%, the beta turned negative, meaning rising inflation expectations hurt equity returns. 

Today, with the five-year BEI rate above 3% and rising, we believe that UK equities look extremely vulnerable to any further rise in inflation expectations. The Bank of England says that while CPI inflation “may remain above the 2% target for the next two years … inflation is expected to fall back to around the target thereafter.” The markets disagree. The five-year forward BEI suggests that markets expect inflation expectations to reach 3.5%—even higher than today—in five years. 

Are inflation-linked bonds a good way to cope? Not really. The display below shows that yields on five-year UK inflation-linked bonds, known as “linkers,” recently fell below negative 2%. In other words, by buying linkers, investors would lock in a return that is 2% below the retail price index (RPI) for the next five years—an unprecedented low. And should an investor need to sell the bond within five years, there’s a risk of capital loss. If interest rates normalize even slightly, that capital loss could more than outweigh the inflation pass-through provided by these bonds. In such a scenario, holders of linkers could face nominal and real losses in a period of rising inflation.

Investors strictly required to match their assets to liabilities often have little choice but to lock in the negative real rates offered by linkers.However, we believe that UK investors with equity allocations should strongly consider diversifying into “real assets” now. Our research shows that portfolios of foreign currency, commodities, real estate and certain equity sectors can provide a positive link to inflation and, if properly constructed and managed, sacrifice little in the way of long-term returns.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio- management teams.

Jon Ruff, CFA

Lead Portfolio Manager and Director of Research—Real Asset Strategies
Jon Ruff joined the firm in 2004 as a senior portfolio manager, and was appointed a director of the Wealth Management Group in 2006 and Lead Portfolio Manager and Director of Research for the firm’s Real Asset Strategies division in 2010, working out of the San Francisco office. He previously served as the senior investment professional for a large family office. Before that, Ruff traded mortgage-backed bonds and monitored proprietary trading risk at Goldman Sachs in the US and Japan. He earned a BS in finance from the University of Virginia and an MBA from Northwestern University and is a CFA charterholder. Location: San Francisco

Patrick Rudden, CFA

Portfolio Co-Manager—Dynamic Diversified Portfolio and International Head—Multi-Asset Solutions
Patrick Rudden was appointed International Head of Multi-Asset Solutions in 2013 and is Co-Manager of the Dynamic Diversified Portfolio. From 2009 until 2013, he was head of Blend Strategies. Rudden joined the firm in 2001 as a senior portfolio manager for Value Equities. He has published numerous articles and research papers, including, “What It Means to Be a Value Investor”; “An Integrated Approach to Asset Allocation” (with Seth Masters); and “Taking the Risk Out of Defined Benefit Pension Plans: The Lure of LDI” (with Drew Demakis). Previously, Rudden was a managing director and head of global equity research at BARRA RogersCasey, an investment consulting firm. He holds an MA in English from Oxford University and an MBA from Cornell University. Rudden is a CFA charterholder. Location: London

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