Will UK inflation be an outlier in 2026?

0:12Hello and welcome to the latest edition of the FTadvisor podcast. I'm David Thorpe, Senior Investment editor at FT Advisor. Today the topic is the outlook for UK inflation after what has been it's fair to say a turbulent period for the UK economy and with the global outlook seeming to be rather murky. Joining me to discuss the topic are Bryn Jones head of fixed income at Rathbone Asset Management, Dean Cook multi-asset portfolio manager at Aviva Investors and Peder Beck-Friis Senior Vice President and Economist at PIMCO. Petr, if we start with you, investors globally have started to worry about inflation being higher for longer.

0:55But do you feel the UK could become an outlier in this regard? No, I don't think so. It's certainly true that UK inflation is higher than other developed market countries. It's high, of course, in the US because of tariffs, But compared to rest in Europe, Japan, Canada, to give a few examples, UK inflation is higher. But I do think the bulk of this reflects regulatory and tax changes from government policies. Certainly, the national insurance hike did not help in terms of inflation. We had VAT on private schools, very high water bills in the spring. So once these feed through and fade into the yearly numbers, then I will expect inflation to decelerate from here.

1:44So we expect inflation to converge back to 2 % at the end of next year, especially in the context of the weakening labor market and also, of course, in the context of the tight fiscal policy that we're seeing. Brilliant. As a fixed income investor, inflation is obviously something that you have to think about and that has a major impact on your asset class. But is the UK inflation outlook something that you're particularly concerned about right now? No, I kind of agree with the previous comments. I think UK inflation has reached its peak. There were lots of issues which caused high inflation that's already been mentioned.

2:25I think the last sticky bit of inflation in the UK seems to be wage inflation which there is a wage inflation being set minimum wage for example next year at 4.1 % that doesn't do anything for reducing wage pressures however unemployment is on the rise quite significantly we think in the UK youth unemployment in particular is a real problem at the moment with youth unemployment running at 11 % which is very high and this will eventually I think have a knock-on effect to wages next year. But in the context of the question, do I think UK inflation is stickier than globally? I don't think so. I think actually it's the opposite.

3:08I think inflation in the UK is more likely to be lower than a lot of people think. And we've already seen wage inflation and inflation pick up in places like Australia only yesterday or this week. eurozone inflation expectations have risen you've got tariff pass through in the us and you know if you look at asia you've got some countries with hyperinflation and other countries experiencing quite significant growth relative to their history so i would put it the other way around actually if it is going to be an outlier it's going to be under global inflation thank you and dean cook multi-asset portfolio manager at aviva as a multi-asset guy How are you thinking about inflation and the significance of it in the portfolios you look after?

3:53And do you see the UK as having a particular inflation problem? Thanks, David. I think Pedder and Bryn have made some excellent points there around the drivers. There's inflation, particularly in the UK, particularly agree that the labour market is showing some signs of cooling, albeit we're probably still running at inflation level there with respect to wage growth that is inconsistent with the inflation target. So I think we're about 2.8 % average wage growth in the UK at the moment. We need 2 to 2.5 really to drift down to target. But we think that the UK is one of those economies that is on its way towards its 2 % inflation target over time.

4:39Similarly, I think brim made the point around australia we had a rate decision overnight from the rba there were no there was no cut to interest rates but the tone was pretty hawkish and you've seen quite a change in interest rate expectations for that market so more or less a 100 basis point swing in terms of where the markets the interest rate is going to be in the middle of next year so when we think about themes and risks for the market, we still think inflation being non-transitory, to dredge up a phrase from the past, is certainly up there, albeit that we don't think that the UK is going to be somewhat as much at risk as other developed markets.

5:22Bryn, as a fixed income investor, does it matter to you, to your asset class, where the inflation is coming from. So, Pedder alluded to earlier, some of the inflation is coming on the supply side, potentially. Does that matter if it's on the supply side rather than the demand side? Well, I mean, yeah, inflation matters to fixed income. Investors fall stop, very high inflation. It's not good for yields generally, in particular the steepness of the curve, which is a problem as well when you throw in things like term premium, fiscal policy concerns. supply sides when it comes to energy we worry less about there's less you can do about that there's less the bank of england can do about that we worry more about the core you know if services inflation is high and other core factors are high that's not good for fixed income investors because it means central bank policy response is unlikely to come through you can have sort of temporary or energy supply shocks which push up the kind of that supply side inflation and you can still get very weak core and in that environment central banks are more likely to cut rates despite having high energy prices so so to a certain extent perhaps we are focusing currently on the demand side if demand side is weak then central bank policy response might come through in which case you want to add duration to your portfolio so perhaps yeah that's that's what we focus more on currently is is on the demand side rather than supply side shocks peder you mentioned in your first answer some of the uh drivers of uk inflation some of them are are policy led some of them are arguably supply side from your perspective does it matter whether the inflation is and should it matter to investors the extent to which the inflation is supply side rather than demand-side driven?

7:23Well, from a fixed income point of view, I think the question is more, does it matter for central banks and will they look through this? And of course, central banks have a long history of looking through supply-side shocks in terms of the inflation impulse that they have led to. One example, Bank of England, of course, 2016 Brexit referendum, inflation went up and they looked through that. I think the difficulty today is that, of course, there's path dependency. We come from a long period of very high inflation, and that makes it more difficult for central banks to look through this because, of course, there's a risk that the longer inflation stays higher, that that would feed into higher inflation expectations.

8:05So I think to some extent what we've seen this year with the Bank of England is they've been very cautious in terms of the rate cuts, given that inflation has been high for so long. But yes, I think that the bulk of what we're seeing now in terms of inflation is, you know, you call it supply side, we call it regulatory and tax changes. I see very little, you know, very small demand impulse that leads to higher inflation in the UK. The labor market, as mentioned before, looks very weak. And frankly, if you look at the consumer side, household savings very, very high. So people are choosing to save rather than consume.

8:45So I think the bulk of this, again, repeating myself here, but I think the bulk of this reflects government policies in terms of regulatory prices, but also tax changes. Thank you. Dean, as a multi-asset investor, obviously, you look at both equity and fixed income and many other things. Presumably, your equity allocation is impacted by whether inflation is supplier demand side. Yeah, to a certain extent, I think you're right there, David. I'd agree with the rest of the panel in terms of the sources of inflation presently in the UK and the session by which the Bank of England has been approaching it.

9:22We think at the margin, some of the more recent changes that have come through from the government vis-a-vis the budget, which I think we're probably going to get onto, potentially reasons to be optimistic with respect to the domestic picture in the UK. And so we're thinking about how we can best express that in portfolios. Dean, if we stay with you for the next question, I mean, you alluded to it in a previous answer was, in your view, what impact does the recent UK budget have? Was it adding to the inflation impulses in the economy or removing them? Yeah, I'll try to give a reasonably straightforward answer here, but I think it slightly depends on the timeframe you're thinking about.

10:07So the headlines, as it were, the energy prices side, somewhat disinflationary to my mind. So the chancellors have removed some green energy levies from bills and frozen fuel duty. but you've also got some increased spending in the nearer term outweighing the higher taxes further out so depending on the impact of unemployment you could see some inflationary impacts in the nearer term but it slightly depends on and hinges on when companies start to take into account measures expected later in parliament term with respect to the tax side and so i think it may take a little while for us to truly see the assays.

10:49Thank you. Pedro, from your perspective, I think PIMCO were on record as saying that, you know, guilds were made more attractive as a result of some of the budget measures. But is it something that's likely to keep a lid on inflation? I don't think the budget impact on inflation will be that meaningful. I agree with Dean in terms of the headline measures, of course, that could bring inflation down by a few tenths in the spring. But in terms of core inflation, I don't see any big impulse from the budget. Now, the important thing to remember, of course, with the budget is that the budget adds to already a very tight existing fiscal tightening path.

11:36So if the UK follows through and the government follows through on the plans that they have announced, UK is on track to run the tightest fiscal policy in all of the developed market next year and beyond. And of course, if they follow through with that fiscal policy, then of course I would expect that to lead to eventually lower demand and lower pricing pressures. So from that point of view, very tight fiscal policy to us increases pressure on the Bank of England to be the shock absorber and pressure on them to continue easing going forward. Thank you. Bryn, what did you make of the budget? Was it altering your view of GILTS or indeed of other UK fixed income assets?

12:21I mean, got to spit that question into two, really. So from an inflation perspective, we thought that similar to the previous two conversations, that the demand side would be impacted negatively, bring inflation down a little bit. However, the time decay of the tax increases are quite significant in their backloaded. And actually, they come through right before the next election. So whether they follow through on those tax increases just before an election is remains to be seen. it could be quite negative for the Labour government to try and do that. So in the short term, yes, kind of we think demands will be negatively impacted, bring inflation down, but we're not sure the policies can actually get implemented fully.

13:08And then the question about gilts is slightly different because, yes, the fiscal tightening will hopefully mean that the government will borrow less over time. so next year we could see a peak in actual issuance and after that issuance dropping which obviously if you think about simple playground economics and demands of supply if you've got lack of supply prices go up but there's two other factors in play in the gilt market the dmo have been quite aggressive of reducing long gilt issuance so in the gilt remit in april they reduced long gilt issuance to just 10 percent and they announced after the budget that they're cancelling all 30-year auctions until next year.

13:49And I thought that was to the next year, but it's naturally till the next fiscal year. And so the long end of the market, if it sees any demand, can rally quite aggressively. Just, again, simple playground economics. And, of course, throw into that mix, quantitative tightening being reduced at the long end by the Bank of England. And you're in a situation where demand and supplies is favouring the long end of the gilt market, with it being the longest or sorry the highest yielding developed market outside of Iceland. I mean actually Iceland hasn't got a 30-year bond so it is the highest yielding developed market so getting a yield and carry in an area where there's going to be a lack of supply in an environment where there could be falling inflation makes long gilts quite attractive and hence why we've been adding them to our portfolios.

14:38Thank you for that Bryn. Pedra, given your view on the inflation outlook for the UK. How does that impact portfolios? Well, so we have liked gilt for a long time. We continue to like gilt in our portfolios. But I do think it's important to differentiate where on the gilt curve. So we in particular like the front end of the gilt curve, five-year point to be more precise. Of course, the front end of the gilt curve is much more sensitive to Bank of England expectations inflation macro outcome. And our expectation, going back to my earlier comments, is that when inflation falls, we would expect Bank of England to cut rates and eventually cut more than what's priced into front end of the market.

15:26We are a little bit more cautious on the long end. The long end, of course, is much more sensitive to fiscal and political developments. So we're a little bit more cautious on the long end. I should put this in a global context. We are pretty cautious on long end bonds in general. And we tend to be underweight US and European long end. We're not underweight UK long end. So in that global context, I guess we're a little bit more positive on UK long end than the rest of the world. But we prefer to take our exposure in the front end of the gold curve. To us, it's much easier to think about Bank of England expectations rather than fiscal developments and political noise, which I'm sure will be with us for quite some time.

16:13Bryn, given your view of the inflation outlook, what do you feel are the prospects for Sterling and is it something that's on your mind as an investor? Let's say for me, Sterling, because my fund sits in the UKI corporate sector. so it's got sterling as its base currency and my global fund is hedged back to sterling so sterling becomes my core position and rarely do I take any currency risk as a bond investor because you get it wrong and basically what do you return out for the year and if you're asking me generally I think sterling is a bit sideways on the one sense we could have rates coming down more aggressively than priced in arguably um you know that that that might be negative for sterling uh but since the last budget and the outlook for the fiscal policy being stronger and people worrying less about um about sterling um that could be more positive on a balanced sense fairly neutral and i once heard that when you look at euros dollars and sterling it's like looking at three drunks in the bar and wondering which one's going to fall over first.

17:27And so, yeah, so in that sense, I don't take a huge amount of currency risk in the portfolios. Dean, as a multi-asset investor, how does your view of where inflation is in the UK impact portfolio construction right now? Thanks, David. I think the rest of the guys have made some really key points. So the fiscal risks that challenge the long end of the gilt market has kept us away from that part of the curve for a reasonable period of time, certainly since the middle of the year. But looking through, we also see the opportunities for UK domestic stocks where we're allocated in portfolios. So thinking about those nearer term boosts to economic growth that could come about from the budget, as I alluded to earlier, and any strengthening of sterling would also help mid-caps outperform caps where there's more domestic earnings.

18:22It's also a part of the market where I think a lot of bad news is priced in, not that very many people own the sector. And I think at the moment, the FTSE 260 offers you a dividend yield about 100 basis points higher than the FTSE 100. And it's certainly a historically wide gap. I couldn't tell you exactly when that goes back to. Given your view of the inflation outlook, what do you feel are the prospects for Sterling? You mentioned in your previous answer of Sterling Strengthened, it would benefit certain asset classes. But do you think that's going to happen? Yeah, so a slightly less contractionary near-term impulse from the budget should imply a slight positive for the currency, we think.

18:58In practice, though, we think maybe part of that can be attributed to the unwind of some more negative tactical sterling positioning kind of coming into the budget. But really, the medium-term path for sterling should be set by its relative interest rate differentials compared to other markets. And so we're more positive on the growth outlooks for the US and Eurozone, but we think that there are some more structural challenges around the valuation of the US dollar. And so we think that Sterling stands to hold its own amongst that peer group. Thank you. Okay, Pedder. at PIMCO you're quite positive on on gilts and relatively sanguine on the inflation outlook but how does that feed into your view of where sterling is and where it could be going something that's impacted many investors this year maybe more on the equity side is the relative weakness of the dollar compared to sterling has dented the returns for many who have US equity portfolios But from your point of view, is sterling, particularly sterling against the dollar, likely to continue its recent trajectory?

20:13So we are broadly neutral sterling at these levels. On our valuation models, it looks broadly fair. If you compare sterling versus the US dollar cable, the bulk of that volatility is driven by the US leg, not the UK leg. So to have a view on cable, you need to have a view of the dollar. But we are broadly neutral now. If we are right in our Bank of England expectations, that Bank of England eventually proves to cut deeper than what's priced into financial markets. And I think in most states of the world, that would lead to a weaker sterling. However, again, going back to my earlier comment, obviously, the FX is much more sensitive to political and fiscal development.

20:58So that leaves us with a broadly neutral stance. and we prefer to focus our exposure in the UK in gilt and in particular in the front end of the curve. Thank you for that, Pedder McFries, Senior Vice President and Economist at PIMCO. And thank you to Brian Jones, Head of Fixed Income at Rathbonds Asset Management. And to Dean Cook, Multi-Asset Portfolio Manager at Aviva Investors. And thank you to John Dowling for being in the production booth. Thank you all for listening. And please do remember to tune in to future editions of the FT Advisor podcast. Thank you.