Inflation is expected to fall over the coming months.

UK annual headline CPI inflation for April was reported at 8.7% down from 10.1% in March.

Core inflation (excluding food, energy, alcohol, and tobacco) was 6.8% up from 6.2% in March.

In the week that Andrew Bailey, Governor of the Bank of England, admitted he was no longer relying on the Bank’s inflation models, we received another surprise with April’s inflation release. Despite a 1.4 percentage point fall in year-on-year inflation compared to March, headline CPI surprised on the upside. More troubling, core inflation recorded its highest reading since March 1992. In last month’s monetary policy committee report, the Bank highlighted that inflationary risks remain skewed to the upside, and once again this has proven to be the case.

The easing in the annual inflation rate was mainly driven by changes in the housing and energy, particularly for gas and electricity. Monthly gas prices fell by 1.0% between March and April this year. This was driven by base effects, with the higher April 2022 Ofgem energy cap dropping out of the annual estimates.

This decline in prices was offset partially by another sharp increase in food and non-alcoholic beverage prices, which increased 1.4% month-on-month and 19.1% year-on-year. The ONS estimates that this is the second highest reading in the last 45 years.

On the back of another disappointing set of data, we saw an instant reaction from bond markets: traders increased their expectations of the peak in UK interest rates from 5% to around 5.5%. Sterling also extended recent gains, rising 0.4% against the dollar.

The Bank of England’s decision on whether to continue its hiking cycle will depend on the incoming data. The latest CPI data increases the probability of another increase at the June meeting.

UK GDP growth held up at 0.1% in Q4 2022 and is expected to remain at 0.1% in Q1 2023 and therefore has avoided recession. The UK has surprised on the upside at the start of 2023 with the FTSE 100 having had a relatively good year so far with gains of 4.4%. The avoidance of recession and a tight labour market has given confidence to the BoE MPC to further rise UK interest rates by 0.25% as the UK inflation rate is a G7 outlier at 8.7%.

JP Morgan revised their UK forecast for GDP growth by +0.3 for Q2 and +1.3 for 2023. This is a boost for the economy but higher growth will add further inflation pressure.

The MCP will weigh the improved economic activity against the tightening already in place. UK interest rates have increased by over 4% in the past 18 months which is a very fast tightening cycle. Until the battle to control inflation is won, the BoE will feel it will have to apply pressure. The Fed have already been more aggressive and have somewhat achieved their goal of falling inflation. The BoE had been slow to act decisively and are now in a harder place with inflation much higher than that of the US. Therefore, the BoE will seek to raise rates until rate rises start to work but that may hurt the economy in doing so.

UK inflation sits at 8.7% while the Eurozone is currently 7% and the USA 5%. Core inflation which does not include food and energy cost and have both added most to inflation recently, is 6.8% in the UK and 5.6% in both Eurozone and USA.

So why has the UK suffered such higher inflation that our peers. There are three main reasons. The UK has endured a big energy price shock just like Europe has. UK energy prices are linked to European rates. The UK has a tight labour market just like the US so wage inflation is more pronounced. The BoE were slow to react to the signs of inflationary pressure early enough unlike the US Federal Reserve. The UK has been hit in three ways.

However, headline inflation is expected to fall over the coming months due to declining energy costs and improved supply chains. The tight labour markets may mean getting inflation back to the BoE 2% target will take longer in the UK. Unemployment is at 3.8% while the number of job vacancies are 1.1 million and there are 1.5 million looking for work who are registered unemployed. The UK employment rate is 75.8% of working age and the participation rate is 78.9% of working age. Core inflation is expected to stay higher than peer countries through to late 2024.

The BoE increased interest rates in May by 0.25% to 4.5% in order to continue to bear down on inflation. The BoE will be pleased that the UK banking system has not endured the rate rise consequences of the US and Eurozone. UK mortgages are more based upon short fixed rates and variable rates as compared to 30 or even 40-year fixed rates in the USA. Hence the mis-match between mortgage payments on low interest rates and deposit interest payments on recently elevated rates is far less acute in the UK as it has become in the US.

Analysts expect that the BoE will be soon forced to decide between driving down inflation or avoiding a damaging recession. The talk from the BoE sounds as if a rate hike, then pause is on the cards.

With an environment of high interest rates, high inflation, and pressure on the cost of living, one would expect house prices to fall and are down 4% from last year’s peak. However, while confidence remains subdued, the outlook over the next 12 months has improved as inflation is expected to fall in the second half of the year and that the employment market remains strong and wage rises are attractive. On the back of this sentiment residential property prices rose by 0.5% in April having fallen 2.7% in the past 12 months.

Our emphasis within our UK asset allocation has been a clear preference for large cap companies over their mid cap alternatives. The FTSE 100 has outperformed the FTSE 250 by 7.7% over the past 12 months to May and by 1.3% over the year to date to May. The FTSE 100 emphasis on energy and financials has been beneficial in 2022 and in Q1 2023. The defensive and value qualities of the companies in the FTSE 100 is attractive in the current economic climate, reflecting our preference for defensive sectors across the board.

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