Early in January, the Bank of England caught the market by surprise by raising interest rates to 5.25 per cent. However, it was always likely that the bank would have to move rates higher fairly soon in response to the pick-up in core inflation over recent months.
Until recently, higher input costs had not been substantially absorbed, either because strong margins had allowed the pursuit of volume or, typically on the high street, consumer resistance had been too strong. This phase seems to be coming to an end.
Money growth is strong and housing is resilient. Wages are also becoming an issue. Real wage growth has fallen from about 4 per cent at the end of 2001 to around 1 per cent and, with significant hits to disposable income from fuel and travel costs, there is a risk of upward pressure on pay settlements. In this regard, the pick-up in inflation is particularly unfortunate timing. Headline RPI of 4.4 per cent is hardly the statistic of choice for a Chancellor trying to keep public sector increases to just 2 per cent.
Domestic trends have to be considered against international developments. There has been much talk of a soft landing to the world economic cycle but there is precious little sign of it. Activity is rising in Europe and momentum is still strong in the US, as attested by the fall in new jobless claimants and the surprising strength in new housing starts.
How threatening is this to investors? The answer is not threatening at all. What we seem to have unfolding is a reasonably standard late cycle scenario. Prolonged economic growth has created nascent inflationary pressures and a few hot spots which central banks are trying to cool. There are no signs of the excess which in the past caused authorities to bring the upswing to a crunching stop.
Continued growth will see further rises in company earnings. Over the past four years, domestic equity market indices and forecasts of future earnings growth have moved pretty much together and, while expectations of multiple expansion are optimistic, there is little justification for contraction.
What strategy should investors adopt? Is it time to be wary of interest rate-sensitive stocks? No – it is far too late for that. A more credible approach is to look ahead, not to the next rate rise but to what comes after – to the timing and circumstances behind the fall in rates that we expect in the second half of 2007.
In equity markets, moderating domestic growth will become a key driver to relative returns. Bigger companies with good growth will become a key driver to relative returns. Those with good growth characteristics and international exposure should do well.
John Kelly is head of client investment at Abbey.