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Red letter day

Last week, Bank of England governor Mervyn King wrote his second letter in just over a year to Chancellor Alistair Darling after inflation broke through the 3 per cent barrier. King cited the rising prices of food and energy for the increase and warned that troubled times lie ahead.

Last week, Bank of England governor Mervyn King wrote his second letter in just over a year to Chancellor Alistair Darling after inflation broke through the 3 per cent barrier. King cited the rising prices of food and energy for the increase and warned that troubled times lie ahead.

He said inflation is likely to rise sharply to above 4 per cent in the second half of the year. His warning is backed up by data from the Office of National Statistics showing that the consumer price index has risen from 3 per cent in April to 3.3 per cent in May.

Rathbone chief investment officer Julian Chillingworth says the statistics confirm fears that inflation could hit 4 per cent as early as the third quarter of 2008.

He says: “What makes it worse is that higher energy and food prices are effectively out of the bank’s control and energy costs, in particular, remain a big unknown. If the world has to adjust to higher oil prices, this could have serious implications for inflation targets.”

In the past 12 months, agricultural prices have soared while oil is now touching $140 a barrel.

Informed Choice director Martin Bamford says consumers are going to have to accept the trend in food and fuel prices.

He says: “In the short term, it is difficult to see how that will be reversed despite economists pointing to a spike in food and petrol prices. The obvious solution is earning more to counteract inflation but the truth is that people will have to address expenditure to keep their house in order.”

Norwich Union senior economist Stewart Robertson expects inflation to peak at 4 per cent, provided that oil prices do not rise further, then to fall sharply towards the end of 2008 and early 2009 as the slowdown in the economy kicks in.

He says: “If food and energy prices moderate too, inflation problems could fade quickly, to be replaced by concerns about the severity of the downturn.”

Eclectica head of sales James du Boulay believes the agricultural boom is only just beginning.

He says: “The real high for soft commodities dates back to the 1970s. Prices are probably 75 per cent off the real peak in 1973-74. We feel that we are now in a 25-year cycle that kicked off 12 to 18 months ago and will surpass all previous highs in the market.”

Hargreaves Lansdown head of research Mark Dampier says it is important to recognise that the current situation is nothing compared with the 1970s when inflation hit 25 per cent for two years before dropping and stabilising in double figures. He says domestic inflation is currently relatively low at 1.5 per cent if food and oil are excluded.

Dampier says: “Aside from agriculture and commodity funds, it is pretty hard to pick exactly where to go from an investment perspective. The likes of gold and, in particular, oil still look attractive as analysts have priced in oil at $60 to $70 a barrel rather than the $140 area it is currently operating in, so even if there was a 30 per cent tail-off it would look attractive.

“From a UK equities’ perspective, you need something fairly flexible like Colin McLean’s SVM 100 UK select fund that has a 61 per cent exposure to resources but has the ability to change tack quickly. UK equity income has been dumped on but will be a big area if markets turn, just as it did with the exchange rate mechanism. I just do not see that happening over summer.”

Schroder head of UK equities Richard Buxton says although inflationary troubles reinforce the likelihood of a near-recessionary environment, there is room for some optimism. He says: “The good news for the UK equity market is that an extremely weak outlook has already been factored in to many UK share prices. You also have the fact that many UK companies are dependent on global rather than UK economic growth trends.”

Fidelity head of IFA channel Peter Hicks believes that unconstrained funds are a promising route for investors. He says: “The most important thing is to be diverse. It sounds obvious but many assume that traditional asset classes are heavily correlated when they are anything but. Most companies are pointing to a slowdown in earnings but not all of them. This is why bottom-up stockpickers are likely to find opportunities in the market.”

F&C head of UK smaller companies and manager of the UK dynamic fund Catherine Stanley says companies which show genuine growth and visibility of earnings are beginning to justify their premium ratings.

She says: “Last year, many investors were talking in terms of bigger companies outperforming small caps. However, right now, we believe that sustainable growth is the place to be and this is true across the market cap spectrum. Our top 10 holdings range from FTSE 100 to Aim.”

Dampier says: “If risk comes back to the market, small caps will be more attractive as a lot of the damage has been priced in. Small caps tend to have unique growth whereas a large cap is likely to get clobbered in a market like this. Small caps have the advantage of controlling business margins and some will have a business margin that operates regardless of the slowing economy.”

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