UK inflation hit 2.1% in May, not only representing the CPI’s largest jump in six months, but, more importantly, exceeding City economist forecasts of 1.8% by a notable margin.

The biggest driver by far was the price of fuel, which, as many readers will have no doubt noticed, has soared in recent times alongside spiking crude oil prices. Meanwhile, other factors adding fuel to the fire included the price of clothes, beverages, and even online computer games and music.

These reasons aside, by far the largest talking point after the news broke was the fact that inflation now exceeds the Bank of England’s 2% target.

With this being the first time this line in the sand has been crossed in two years, it leaves many wondering where prices will go from here and how to mitigate the effects of inflation whether over the long or shorter-term.

Opposing schools of thought

Inflation has only exceeded The Old Lady’s preferred limit by a tenth of a percent—a breach that may barely seem worth mentioning on first glance.

The issue is that there are two highly opposing schools of thought when it comes to what this means for the future.

The first, shared by the vast majority of BoE policymakers, is that the breach is essentially unsurprising given the events of the last 18 or so months. In fact, the consensus view among this party is that inflation will rise even further, hitting 3% by the end of the year before gradually retreating back to “normal” levels from 2022 onwards.

Why? The rate of economic recovery in the UK is currently so substantial, it’s hardly shocking that prices would be rising by so much as we head out of our homes and spend money we were unable to last year.

The other school of thought has taken a much more bearish attitude towards rising inflation.

Their main concern is that, given the sheer level of recent disruption to the UK economy, we could quickly hit levels of hyperinflation not seen since the 1970s.

The BoE’s chief economist, Andy Haldane, has voiced his concerns. Admittedly, he has yet to go so far as to suggest that we could shortly find ourselves paying for a loaf of bread with a wheelbarrow full of cash. However, he has warned that it is more and more likely that the UK’s rate of price rises is likely to follow that of the US, which recently reached 4.2%.

The importance of pricing power

Whichever way you look at it, these eventualities will have consequences for businesses. Inflation always does—it’s an inescapable part of the economic phenomenon.

That’s why an absolutely essential factor for us when picking any stock is how resistant it is to the rising tide of prices. After all, the more “inflation proof” a company is, the more likely it is to thrive in any circumstances.

For us, a key indicator of a stock’s resilience here is its degree of pricing power.

Indeed, the stronger a company’s branding and intellectual property, the more loyal customers are to its products. And the more flexibility a company has to increase its prices in response to inflation without losing customers, the more likely it is to be able to weather any inflation storm and maintain—or even increase—its margins and profitability.

One classic example is Guinness currently owned by British beverage behemoth Diageo.

From just 1.25p in April 1900, a pint of the ‘black stuff' today will set you back around £7.20 in central London. That’s a 575% increase in price!

The point is, that because the Guinness brand is so strong, the price has consistently been able to outpace inflation throughout history.

On the flipside, televisions are an example of a product that has not been so resilient to inflation over the years. Flat-screen TVs could easily have fetched a price tag north of £10,000 back when they were first introduced by Fujitsu in the mid-nineties. But fast forward to today, and a 55”, top-of-the-range, ultra-HD Samsung TV would cost you around £480.

The reasons for this are twofold.

First, the TV supply chain has become much more efficient, meaning companies can manufacture and sell TVs at a vastly lower price. And second, TVs are essentially exactly the same once you take away the branding, with far fewer differentiating features than equivalents like smartphones and tablets.

Essentially, electronics brands have had no other choice than to lower their prices—regardless of inflation.

Positioned for positive returns

We don’t yet know whether inflation will continue to soar or return to normality over the next year and beyond. In fact, this sort of crystal ball gazing is often a very thankless task.

What we do know, is that whatever happens companies with pricing power will be in the strongest position. This always has been, and always will be, the case.

With this in mind, we believe that—in this world of extreme uncertainty and rising prices—a portfolio of equities with the ability to increase their profitability dependably offers investors the greatest chance of consistently generating positive returns.

 

Sources

https://www.theguardian.com/business/2021/jun/25/bank-of-england-andy-haldane-uk-inflation-risk-us

https://www.theguardian.com/business/2021/jun/24/bank-of-england-rejects-interest-rate-rise-despite-inflation-worries

https://www.theguardian.com/business/2021/jun/16/uk-inflation-jumps-petrol-clothing-prices-rise-bank-of-england

 

First seen in Professional Adviser

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