Deflation station: Fidelity International’s Maike Currie explains where to invest in a world of no inflation

It is likely that I will have to write further open letters to you over the coming months…”

 

If you think these are the words of a hopeless romantic penning a letter to their long-distance love, you’re wrong. It’s the Bank of England governor Mark Carney, writing to chancellor George Osborne to explain why UK inflation remains so far below the Bank’s two per cent target. 

 

The words come from the fourth letter Carney has sent to the chancellor this year. It followed an unexpectedly benign November Inflation Report, and with UK consumer price inflation having see-sawed either side of zero since February, the governor is going to need a good stock of stationery.

 

With consumer price index inflation dipping into negative territory three times this year – in April, September and October – the concern is that the UK economy is treading a fine line between “good” and “bad” deflation.

 

While Carney has made it clear in his letters explaining the inflation undershoot that UK price rises are likely to remain below the 1 per cent mark until the second half of next year, he has also continually stressed that we’re not experiencing bad deflation.

 

The primary driver of the UK’s record low inflation is the collapse in commodity prices, driven in large part by a slowdown in the emerging world. The strong pound has also kept a lid on import prices. These are external factors, and while they’re capping food and fuel prices, they’re not changing consumer behaviour.

 

No-one is going to delay their weekly trip to the supermarket or stop filling up their car’s petrol tank because they expect prices to fall next month. You need to eat and get to work. Deflation is dangerous because it causes consumers to do the exact thing that causes more deflation – delay spending in the hope of further price falls in the future. Japan remains a salutary reminder of the devastating impact a self-perpetuating spiral of deflation can have.

 

But what happens when these temporary pressures fall out of the equation? The Bank of England’s chief economist Andy Haldane argues that, over time, the external factors weighing on UK inflation will wane, and then the key factor that will determine the future path of inflation will be domestic costs, specifically labour costs.

 

The UK labour market has been an unpredictable beast in recent years, with wage growth remaining lacklustre despite the strong rise in jobs. One reason why wages are staying relatively low could be that technology has made it easier and cheaper to substitute machine for man. Interest rates could stay low for the foreseeable future if low inflation turns out to be less cyclical than structural.

 

Of course no-one is going to complain about falling prices. The pound in our pockets is going a little bit further than it did a year ago, which boosts our spending power. That’s good news, not least because consumer spending remains the backbone of the UK economy.

 

But the consumer’s gain is the saver’s pain. The trajectory of interest rate rises is expected to be as muted as the outlook for inflation. On the basis of the Bank’s own projections, the only way inflation will be back above the 2 per cent target in two years’ time is if any rate rises are limited to two quarter point increases in 2017. That means interest rates will be just 1 per cent a decade after the start of the financial crisis. 

 

Persistently low interest rates mean that, for investors and savers, the search for income continues. This should boost the case for equities and equity income funds, further underpinned by an ageing population seeking ways of securing a decent return in retirement. The inflows enjoyed by Neil Woodford’s equity income fund are testament to this. 

 

Investors seeking equity income with added oomph can look to enhanced income funds like the Fidelity Enhanced Income fund, managed by Michael Clark, who also runs the Fidelity MoneyBuilder Dividend fund. The Enhanced Income fund aims to generate a higher income than the ordinary equity income version by selling to other investors the right to buy shares owned by the fund at a slightly higher price than they would have to pay in the market today. It receives an upfront payment, or premium, in exchange for that right (known as a covered call option), and the premium is passed on to investors in the form of a higher dividend.

 

While the demand for income solutions, specifically in the multi-asset space, will increase, growth will be at a premium. Quality companies that boast strong cash flows, don’t rack up debt and have pricing power will become more expensive, because they’re far more valuable in a world characterised by low growth, low inflation and low interest rates. Just ask fund managers like Terry Smith of the Fundsmith Equity fund, Nick Train of the CF Lindsell Train UK Equity fund, and Clyde Rossouw of the Investec Global Franchise fund, who all seek out these types of companies.