The Bank of England (BoE) believes September’s 3.8% CPI reading should mark the peak of the current inflationary cycle. Is the end in sight? asks Alan Dobbie, Rathbone Income Fund Manager.
The BoE’s November Monetary Policy Report notes that, beneath the headline figure, wage pressures and persistently sticky services inflation have eased. The BoE expects inflation to get within touching distance of 3% early next year and continue falling gradually to 2% over 2027. While the BoE’s interest rate-setting committee is divided about the exact timing of further cuts, it seems clear that as long as the disinflationary trend remains intact, rates will continue to come down.
If the BoE is correct, this could have meaningful implications for which sectors and stocks are best placed to outperform in the next phase of the cycle. For fund selectors, understanding these dynamics and how portfolios are likely to behave is essential.
Alongside the BoE’s dovish view, there are strong hints that the Chancellor may be forced to pull one of the major tax-raising levers in the upcoming Budget, which could further extinguish any lingering inflationary flames. While increasing income tax rates, or reducing the threshold level at which different rates kick in, may be politically difficult, the hit to household finances would likely exacerbate the slowdown in both inflation and the nation’s economic growth.
More positively, if the Chancellor succeeds in convincing the bond market that the UK’s fiscal position is stabilising, bond yields should fall, reflecting a reduced risk premium. Any move lower in UK yields would have both direct and indirect implications for equity sector leadership. This also informs our own fund’s positioning.
There are two broad categories of stocks that typically benefit from falling bond yields.
Bond proxies: long-duration stocks
These companies with predictable, long-term cashflows have valuations that are sensitive to interest rates. Falling yields obviously reduce the discount rate, pumping up the present value of future earnings and supporting their share prices.
Regulated utilities are a key example. The highly predictable cashflows made by electricity and gas network owners such as National Grid and SSE means they often outperform when bond yields decline. While we expect this to continue, an interesting nuance this time around comes from how their investment narratives are evolving.
Both companies are undertaking large-scale grid upgrades to support a decentralised, renewables-driven energy system. For instance, National Grid’s £60 billion investment plan over five years aims to grow its Regulated Asset Base (RAB) by 10% annually. Historically, RAB growth has been another key determinant of relative share price performance. A combination of falling bond yields and strong RAB growth could turbocharge performance. On top of that, attractive dividends, indexed to inflation, provide a further fillip to total returns.
Rate-sensitive cyclicals
Lower rates reduce borrowing costs – for households and businesses as well as governments. While this provides a boost to highly leveraged firms, it can also stimulate demand in interest-rate-sensitive sectors, such as housing, even if overall economic growth itself is muted.
The last few years have been tough for UK housebuilders. Higher costs for materials and labour have coincided with reduced demand for new homes on the back of sharply higher mortgage rates. Yet there’s definitely pent-up demand there: just look at rents if you have any doubts.
Any downward shift in the cost pressures housebuilders face should enhance margins. Greater mortgage affordability and availability would, simultaneously, stimulate demand. Companies like Persimmon and Taylor Wimpey, which we own in our fund, are attractively valued at 11 to 12 times next year’s earnings, with above average dividend yields. They are poised for any shift in the macro dynamics.
The best of both!
Real estate remains a key area for us, as these are bond proxies and direct winners from lower financing costs. UK Real Estate Investment Trusts (REITs) with secure, long-term rental income – like our holding Primary Health Properties (PHP) which leases purpose-built GP surgeries to the NHS – stand to gain from falling discount rates. In addition, with leverage now towards the upper end of investor comfort levels following PHP’s acquisition of key competitor Assura, any decline in borrowing costs would boost profitability and improve investor confidence. With many REITs still trading well below their net asset values, it’s no surprise that private equity interest in the sector is intensifying.
A tilt, not a bet
While we have confidence in the outlook described above, portfolios positioned for falling inflation and yields should still maintain balance. Recent inflationary swings serve as a reminder that macro forecasting is inherently uncertain and diversification essential.
We have tilted our fund toward sectors and stocks best placed to benefit from peaking inflation, while preserving meaningful exposure elsewhere. This ensures resilience across a range of macro scenarios. We believe a well-constructed portfolio should reflect the macro backdrop, while never depending on it.
So if September’s CPI reading does mark the peak of inflation, the shift to a lower-yield environment could reshape sector leadership in meaningful ways. Utilities, housebuilders and REITs stand out as potential beneficiaries. However, the unpredictability of macro trends demands caution. In investing, conviction matters, but resilience wins.
This is a financial promotion relating to a particular fund. This information should not be taken as investment advice or a recommendation. When you invest your capital is at risk and you could lose some or all of your investment.
