Market update: Inflation – the gift that keeps on giving.

Market update: Inflation – the gift that keeps on giving.

This week has been a busy one for UK economic data. The headline figures clearly follow recent trends with wages rising rapidly, unemployment near historic lows and inflation falling. But below the headlines the picture is more complicated. Exclude food and fuel and inflation hasn’t budged. The cost of services, particularly travel and leisure, is still rising fast and the decline in oil and gas prices from last year’s highs will not last much longer and this will be concerning for the Bank of England. Markets have not been slow to notice and the potential for a 0.5% hike in September caused gilt yields to rise. The US Fed has indicated it also remains concerned about inflation and bonds yields have risen in the US. Meanwhile, strong wage growth in the UK needs to be set against declining retail sales. The cold and wet July means we shouldn’t read too much into one month’s data, but the last two years have seen a clear drop in sales volumes as the value of sales has risen. Put simply, people are buying
less as prices rise. While some companies have protected profits by raising prices this means revenues will have declined at others.

Headline inflation continued its steady decline as lower fuel costs helped the Consumer Prices Index fall from 7.9% to 6.8% in July. Food costs continue to
make up a significant part of CPI inflation but this is also dropping quite fast. However, markets were disappointed by the lack of movement in core inflation (excluding
more volatile food and fuel costs) as this was unchanged. UK unemployment ticked up slightly, but wages continue to rise at a record rate as average earnings increased by 7.8% in the second quarter. Gilt yields have increased sharply as markets weigh the chance of a larger 0.5% hike at the next interest rate meeting in September. US government bond yields have also been rising. The minutes from last month’s Federal Reserve interest rate meeting showed concerns about sticky inflation. In addition, strong retail sales mean investors have been reviewing the assumption that the Fed has finished raising interest rates.

CHINA: EQUITIES FALL DUE TO WEAK GROWTH AND PROPERTY CONCERNS
Chinese equities fell as disappointing economic data and a surprise interest rate cut contributed to poor investor sentiment. The People’s Bank of China cut its benchmark rate for one-year lending from 2.65% to 2.5% at the start of the week in advance of the poor data releases. Chinese retail sales increased by 3.1% over the previous year, but this is far short of the 4.6% growth expected. Industrial production has also fallen behind expectations. Unemployment increased very slightly but the government
has stopped publishing youth employment data completely as it remains above 20%.Investor confidence has also been rattled by two big wealth managers failing to make payments on their investment products and Country Garden, one of China’s largest property developers, suspended some onshore bonds after it missed payments to international investors. House prices have also resumed their slide after the respite seen in May and June and the lack of significant government stimulus caused an outflow of capital in recent days.

EQUITIES: INSURERS LOOK FOR THE POSITIVE IN HIGHER GILT YIELDS
Insurers are reaping the benefit of higher UK gilt yields as several of the UK’s biggest firms report strong demand for annuities. Aviva increased its dividend as
it reported stronger trading for its first six months. Overall profits increased 8% to £715m due to greater demand for private health insurance and higher annuity sales. Legal& General also said better annuity sales helped it beat expectations, although overall profits fell slightly. Annuity specialist Just Group is on track to beat its full year profits forecast. The rapid rise in government bond yields means annuity rates have increased by almost 50% in the last two years. Rising yields have also improved the funding position of final salary pension schemes and many have eliminated their funding deficits. This makes the option of using a bulk annuity purchase to offload future liabilities a realistic option for many sponsoring employers. Stronger sales have improved the outlook for life insurers following a difficult last few years which has seen them lag the broader market