Three steps for investors as inflation cools to 3.2%

Price pressures on UK households have continued to assuage after inflation cooled to 3.2% in March, down from 3.4% the month before and a fresh 2.5-year low.

The consumer prices index (CPI), the UK’s main measure of inflation, has now fallen 0.8 percentage points in the past two months, as the Bank of England nudges closer to its 2% target.

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Grant Fitzner, chief economist at the Office for National Statistics (ONS), said that slowing food prices drove March’s fall, which were partially offset by rising fuel prices.

In a further encouraging sign, annual core inflation, which strips out energy and food costs, eased from 4.5% to 4.2% between February and March.

Inflation’s path back to a more respectable level is welcome news for investors. When prices rise at a slower tempo, your savings and investments don’t need to work as hard to retain their buying power.

For this reason, you may assume you only need to switch-up your portfolio when inflation heats up. But any shift in the economic climate should prompt you to check that you’re doing the right things – or perhaps more importantly, swerving anything harmful.

Before we look at what investors should consider in periods of disinflation, let’s first examine the task facing central banks on both sides of the Atlantic.

US inflation digs its nails in

In contrast to the UK, price rises across the pond are proving much harder to rein in.

US inflation came in hotter than expected in March, accelerating from 3.2% to 3.5%. Energy and shelter costs were the main driver for this upswing, which has dashed the prospect of imminent rate cuts.

There were hopes that the US Federal Reserve (Fed) could act as early as June, but September now looks more likely.

The Financial Times reported that US Fed chair Jay Powell said that US inflation is “taking longer than expected” to hit target, which has cast doubt on whether rates will be cut at all this year.

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The US is undergoing a prolonged battle with inflation, which has stubbornly refused to soften since the middle of last year. In fact, prices are rising 0.4 percentage points faster than they were in June 2023, and have sped up for two months on the bounce.

And it’s not just the headline figure that’s proving problematic. Core inflation was 3.8% in March, broadly the same as the month before and higher than what economists expected.

Will the Bank cut rates before the Fed?

It’s long been assumed that the Fed would be the first central bank to cut rates with other developed economies following its lead. But the latest data suggests things may pan out differently.

At an International Monetary Policy (IMF) event in Washington DC yesterday, the Bank of England’s governor Andrew Bailey said: “I think there’s more demand-led inflation pressure in the US than we’re seeing. So, I think the inflation dynamics are different.”

Bailey added: “Our judgement with interest rates is how much do we need to see now to be confident of the process.”

The IMF reckons UK inflation will remain around 2.5% this year, before falling to its 2% target in early 2025. The Bank is more optimistic, believing this will happen in the next few months and some economists share the same view.

The table below shows the trajectory of inflation in both the US and the UK during the past 12 months.

The Bank of England’s growing predicament

Despite inflation easing significantly on these shores, and Bailey’s encouraging words, UK policymakers still face some tough decisions.

In the past week alone, the IMF issued mixed statements on when the Bank should loosen monetary policy, underscoring the delicate balancing act at hand.

On Monday 8 April, the IMF warned that the high number of UK borrowers on fixed-term mortgages means policymakers should avoid keeping rates too high for too long.

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Those on previously cheap mortgage deals may have been shielded from higher rates until now but could see monthly payments rocket unless the base rate comes down.

But just a few days later, IMF managing director Kristalina Georgieva claimed that high inflation across the developed world was “not fully defeated”, urging policymakers to resist calls for early cuts.

Further mixed signals can be found in the UK jobs market, which will have some impact on when the Bank feels timing is ripe to wield the axe.

ONS data shows that annual earnings rose 6% in March. This marked a 0.1 percentage point drop from February but came in higher than expected. However, between December and February the unemployment rate ticked up 0.3 percentage points to 4.2%.

Three steps for investors to take as inflation continues to ease

1) Revisit your asset allocations

When inflation softens and interest rates start to fall, stocks tend to rise. Clearly, as the situation in the US illustrates, the path to lower inflation is not set in stone and when interest rates will fall remains unclear.

Investing, however, is a long-term pursuit, so any portfolio tweaks should be made with the big picture in mind. That said, there are some things to be aware of should UK inflation continue to cool over the coming months, which is widely expected.

As ii’s bond expert, Sam Benstead, noted in his latest bond column: “Investors get more protection from rising interest rates if they own shorter bonds. However, if there is a bond market rally – driven by lower rates – then they will have lower capital gains than other bonds.”

He went further: “A big economic slowdown would lead to this, causing longer bonds to rally more than shorter ones. This is the diversification benefit of bonds – in times of economic stress they should move in the opposite direction to equities.”

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The message here is that holding a mixture of long and short duration bonds can be an effective way to support you from whatever the economy throws up.

The benefits of diversification also apply to other parts of your portfolio, notably stocks. While some sectors typically fare better than others in periods of disinflation, such as healthcare and consumer staples, hunting short-term wins with large chunks of your portfolio can be risky.

For those who prefer a more hands-off approach, a more appropriate strategy is to make sure your investments are diversified across various regions, sectors, and asset classes.

2) Keep drip-feeding investments to smooth out volatility

Few fireworks are expected from markets this year. The “higher-for-longer” inflation environment, which may persist beyond what some economists predicted a couple of months ago, may dampen market gains.

We must not forget that the UK is in a “technical” recession, although the latest GDP figures, which came in better than anticipated, suggest this might be transient.

After the UK economy saw slight growth for the second month in a row, John Glencross, CEO and co-founder of investment company Calculus, said: “The slight growth seen in the second quarter indicates that the UK is steadily emerging from a relatively short recession in record time.”

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Still, the market turbulence we’ve seen so far this year is expected to play out for the rest of 2024.

So, if you’re saving and investing for your future, continuing to drip feed money into the market on a regular basis, otherwise known as pound cost averaging, is a great way to smooth out any volatility.

3) Review your cash holdings

Cash may not offer the potential for high returns, but it’s still a core component of any well-balanced portfolio.

After today’s news, the top savings rates are beating inflation by an even wider margin, so you might be tempted to keep your cash holdings on the heavy side. Although over the longer term this can be harmful.

Schroders, the investment manager, analysed historical data and found that for periods of three months or less the likelihood of cash or shares beating inflation is broadly the same.

However, when it comes to investment periods of 20 years, Schroders’ found that the likelihood of equities outstripping inflation was 100%, whereas with cash it’s about 60%.

There are, of course, good reasons to hold cash: emergencies, short-term purchases, and some dry powder to seize stock buying opportunities should they arise to list a few. But with any additional savings you don’t need to touch for five years or more, the stock market should prove a better horse to back, despite improved savings rates.