Research Edge Position: Short UK (EWU), Short British Pound (FXB)
When we speak of “imported” inflation we’re talking about the relationship between the strength of a country’s currency versus the price of goods and services it imports. With respect to the UK, an import and service based economy, the depreciation of the British Pound since mid ‘08—which we’ve named The Pounded Pound—has bred inflation (for both Producers and Consumers) as the depreciation in the currency has not only diminished purchasing power for its citizenry at home (as more money is needed to chase goods and services), but it has also reduced purchasing power versus its primary import partners. Finally, the global appreciation in the price of oil, denominated in US dollars and therefore boosted by the inverse correlation of depreciating USD (without consideration of supply and demand dynamics), has inflated energy costs for importing nations like the UK.
Therefore, with the depreciation of the Pound and the rise in oil prices (a major cost component for Producers), it comes as no great surprise to see a sequential and annual rise in the UK Producer Price Index. In fact, Input Prices, the materials and fuels manufacturers buy, rose 2.6% in October versus the previous month, while Output Prices, or what manufacturers sell, increased 0.2% sequentially or 1.7% Y/Y. The take-away here is (see chart below) that cost inputs are trending positive and upward in the UK, while outputs have remained positive, but stable over the last year. This price inflation should compress margins for Producers, costs that will eventually be passed on to the consumer.
If the above rhymes, we must also mention that UK Consumer Price Index, in aggregate, has declined over the last months, from 1.6% in August Y/Y to 1.1% in September. This decline can be attributed to a sluggish economy, still searching for growth with Q3 GDP registered at -0.4% Q/Q, annual declines in energy costs, and rising unemployment, all of which should put pressure on broader fundamentals. Further we hold that with the Treasury continuing to print money, including issuing a second wave of bailouts to RBS and Lloyds to the tune of 40 Billion Pounds this week, and the BOE expanding its bond purchasing program while keeping rates steady at a historic low of 0.5% will sustain a weak Pound, which should encourage inflation.
In our virtual portfolio we remain short the UK via the etf EWU and short the Pound via FXB. We expect to see continued underperformance in UK fundamentals. With the economy looking to return to moderate growth by the end of the year, Producer Inflation may remain a major headwind over the intermediate term.