The latest inflation statistics made the headlines. Rather than the expected reduction in CPI inflation, prices remained unchanged in May , with core inflation showing a small rise. In response, in late June the Bank of England announced a 0.5% increase in interest rates, sending new mortgage rates above 6% and creating concern about a major downturn in the UK economy.

These challenges are not unique to the UK: the US Federal Reserve has paused its rate hikes but has increased its expectations of future interest rate rises. The European Central Bank has raised interest rates by 0.25% and signalled that it will continue its upward path. That said, the UK is facing several headwinds, including the tightness of its the labour market and consequent strong wage data.

There are factors that could relieve the pressure in the coming months. Falls in energy prices should start to be reflected in the data. The economy may also start to feel the effects of higher mortgage rates as fixed rates taken out in 2020/21 come to an end. That will squeeze household incomes and deliver some of the dampening to the economy that the Bank of England wants.

Despite the challenging current situation investors should bear in mind the age old saying that “the cure for high prices is high prices”. Interest rates work with a lag and there has already been a significant tightening. While UK inflation remains higher than policy makers would like it is worth remembering that we are most likely much closer to the end of the tightening cycle than the start. Weakness in high quality domestic UK stocks should be considered a long-term opportunity in our view.

A stronger pound

A notable side-effect of higher UK rates has been a rise in Sterling. While this needs to be put in context of long-term weakness for the UK currency, it has still had a discernible effect on the FTSE 100 in the short-term and may act as a modest headwind for the market and for dividends.

There are two elements: one is the translation effect - the share of a company’s revenues generated in foreign currency and how they’re affected by exchange rates. Then there’s the transaction effect, which is the difference between a company’s costs and revenues.

From a translation perspective, around 70% of revenues from UK market come from overseas, so a stronger sterling can be a negative for UK revenues and profits. For every 1% increase in sterling, it reduces revenues by around 0.7%. It will be a headwind, but not a dramatic one.

There are also companies that pay dividends in Dollars. The Sterling value of Dollar dividends will drop if the pound is strong. There are some large Dollar payers in the UK market, but DIGIT collects around 70% of its dividends in Sterling, so this is not a significant exposure for us.

Where we are more alert is on the transactional exposure. If a company is earning revenues in Dollars, but its costs are in Sterling, this can significantly hit profits. It isn’t common, but some exporters may see some pressure on margins. There are also companies that do well. Retailers, for example, tend to buy a lot of products in Dollars, so a stronger Sterling can be helpful.

There may also be some deflationary benefits from a stronger sterling as imported goods become cheaper.

The ‘canary’ sectors that signal recession

This month saw a high-profile profits warning from recruiter Robert Walters. The group still sees a reasonable pipeline for jobs and wages but has seen delays to hiring and weaker confidence. The recruitment sector can be a bellwether sector for economic weakness, dipping earlier in the cycle than others. Similarly, we’d also point to the construction market. New housebuilding volumes are down substantially, and the sector looks to have a tough summer ahead.

The early signs from these sectors supports our judicious outlook, reflected in the balance of holdings we have in the portfolio and its quality and income focus.

Recent acquisitions reflect these priorities. We have bought Softcat, a provider of IT infrastructure to the corporate and public sectors. It has a strong market position and has also been successful at growing its wallet share with customers. IT spending should be an area of resilience even in a weaker economic environment. We have also bought a position in Mercedes-Benz, which is currently trading at a very lowly valuation and has strong cash generation and a robust balance sheet. Its focus on premium customers should also serve it well in a more constrained economic environment.

Tougher outlook for energy

Falling energy prices may ease inflationary pressures, but they are not necessarily good news for energy providers. We hold SSE and Total in the portfolio, both of which have some exposure to energy prices.

However, looking at SSE in more detail, the link between profits and energy prices is inexact at best. A significant share of the group’s network business is inflation-linked, so there is a hedge to energy prices. There is also some hedging of energy prices in place. Also, energy prices remain high by historic standards, so even if they remain at their current levels, it would be supportive for the business.

Equally – and far more important to long-term investors - SSE is playing a vital role in helping transition the UK’s grid to support low carbon energy sources. There is a huge amount of investment required to make this happen, and SSE will see its asset base growth as a result. It is ploughing considerable capital into its networks and renewables businesses, and its renewables business is set to double by 2027. It is a business that is changing shape, while still paying an attractive dividend. Falling power prices do little to dent its long-term prospects.

Companies selected for illustrative purposes only to demonstrate the investment management style described herein, and not as an investment recommendation or indication of performance.

Important information

Risk factors you should consider prior to investing:

• The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested. 
• Past performance is not a guide to future results. 
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years. 
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV. 
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares. 
• The Company may charge expenses to capital which may erode the capital value of the investment. 
• Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss. 
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value. 
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen. 
• Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate. 
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends. 

Other important information:

Issued by abrdn Investments Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

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