The five year breakeven inflation rate is defined as the average rate of inflation over the next 5 years that would result in the performance of holding a fixed coupon bond equal to holding an inflation linked bond with the same maturity.
Dollar oil prices had fallen in 2014-15. Oil prices have risen recently, so petrol prices would have risen anyway, without the pound's decline. But again this impact will now be larger. This will feed through into the petrol pump, and will likely force the Chancellor to offset this by not raising petrol duty and even vehicle excise duty in next spring's Budget.
Despite this rise in input costs, service sector inflation may remain low. In fact, the impact on retail prices will depend upon a host of factors, including competition and demand, which in turn are influenced by inflation expectations and wage behaviour. Wage growth has remained subdued across the economy and this remains the case, hovering above 2%.
We should expect people to still remain price sensitive and this may force firms to limit price rises. One possibility is that some firms could absorb any pick-up in costs on their margins, in order to keep prices down and so retain market share. Corporate profit margins are high, rising since after the financial crisis. For instance, across the economy outside of the oil sector they are over 18% of gross trading profits. When the pound collapsed in 2008, such margins fell from just under 18% to around 14% before recovering. The same seems likely now. Alternatively, with employment still high and if the economy were to grow steadily, then higher wage growth may ensue, allowing firms to keep margins high and pass on higher prices. In that case inflation could peak at an even higher level.
Although any squeeze on domestic margins might be seen as negative for UK equities, the reality is that other factors may have a more positive impact. For instance, with 72% of the earnings of the FTSE100 being overseas driven, the currency effect dominates for many. Furthermore, a continuation of an accommodative monetary policy by the Bank of England could be supportive.
The likelihood is that inflation will peak towards the end of next year, perhaps even early in 2018, around 3%. We had already previously anticipated some pick up in inflation, hence diversifying across our portfolios into higher quality assets to reflect this, taking into account the possible impact on gilts. That being said, holding gilts is still a very sensible part of many portfolios, particularly if the Bank of England's assessment of this as a one-off pass through of inflation proves correct. Indeed, we feel markets may be too aggressive in their forward inflation projections. The graph shows the market's five year ahead inflation expectations; these have been stubbornly above the two per cent target this year, and have peaked recently above three per cent. Although an increase in the market's inflation expectations is justified, the market's view of a five year break-even inflation above 3% may be too high. Instead, after rising during 2017 it still seems sensible to expect the 2% inflation target to be viewed as an achievable anchor in the future, and possibly even back in sight during 2018.