The trading strategy to beat UK inflation menace 

The current squeeze on margins will be bigger than expected as companies struggle to adjust prices fast enough, argues this analyst.

Investors should tilt portfolios towards quality stocks with high margins and profitability in order to withstand an inflation-driven “reality check” for markets later this year.

The recommendation from analysts at Liberum came on the day that the rising cost of fuel and clothing pushed UK inflation to the highest level in almost two years at 2.1%.

Liberum believes that the current squeeze on margins will be bigger than the City is currently expecting as companies struggle to adjust their end prices fast enough.

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It predicts a reality check for investors over their assumptions for the pandemic recovery, particularly for those stocks with lower profit margins and higher growth expectations.

The research note said: “Analysts are upgrading corporate earnings for 2021 at ever increasing speed.

“We think this is too optimistic since the fast increase in inflation and long-term bond yields creates a temporary margin squeeze that reduces earnings growth in the second half.”

This should mean the temporary outperformance of quality stocks with high profitability and the temporary underperformance of value stocks over the second half of 2021.

However, Liberum notes that value investors should then be able to pick up attractively priced stocks during a recovery in 2022.

The sharp rise in UK inflation failed to knock the London market out of its stride today, with investors focused on the outcome of tonight's meeting of the US Federal Reserve.

The FTSE 100 index edged up to a new pandemic high of 7,175, while the domestic-focused FTSE 250 index was just 0.2% lower.

The steady performance reflects the global view that inflationary pressures are transitory, with most of Wall Street thinking that US policymakers won't signal an unwinding of stimulus measures until August or September.

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However, Panmure Gordon chief economist Simon French said today's inflation data in the UK strengthened the case for an early end to the Bank of England's asset purchases.

He said: “Unlike the US where inflation is likely to have peaked in May, UK inflation is set to build through the second half with no repeat of Eat Out to Help Out, the higher energy price cap and pricing power in domestic hospitality.”

Paul Dales, chief UK economist at Capital Economics, believes the re-opening of the economy will push CPI inflation towards 3%, whereas he had previously forecast a peak of 2.6%.

He is also a little less confident that CPI will drop back below 2% next year.

However, Dales still remains hopeful that there is enough spare capacity to force businesses to absorb higher costs by either limiting their profits and/or restraining wage growth.

“But the risk is that the sustained rise in inflation above 2% we expect in late 2023 or early 2024 happens sooner,” he added.