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BLOG: Income squeeze likely to improve faster than expected

Paloma Kubiak
Written By:
Paloma Kubiak

Retail sales data was weaker than expected while inflation dropped by more than anticipated. Given the economic data, there is good news for the hard-pressed consumer.

Hardly a day goes by without a headline highlighting the woes afflicting the British high street. While the weakness is in part down to the weather and the increase in online shopping – a trend which isn’t going away anytime soon – one of the key reasons for the recent weakness in retail sales had been inflation coming in higher than wage growth.

But here is the good news – the squeeze on real incomes is likely to improve faster than many people expect.

Wage growth is picking up and with UK unemployment at the lowest level since the 1970s, wages could well be rising by over 3% by the end of the year. The even bigger positive is that inflation is set to continue falling and quicker than many expect. The recent decline in inflation is just the start of a trend, which is set to continue.

While inflation is generally expected to fall, what is under-appreciated is the pace at which it could fall. The rally in the pound since the start of 2017 could easily cause imported goods costs to switch quite quickly from being a significant contributor to inflation to a downward drag on prices. If the rally in the pound causes inflation to fall as quickly as we expect, inflation could be back at or even below target by the end of the year.

The implications are important. Lower inflation combined with higher pay will make consumers feel better off. There has historically been a strong correlation between real wage growth and consumer confidence. The recent small improvement in consumer confidence could be just the start of a more significant improvement to be seen over the rest of the year.

Historically, consumer confidence has been strongly correlated with retail sales, as one might expect. If we’re right that inflation will continue to fall quickly, real wages will rise and consumer confidence should increase, meaning that retail sales are likely to improve by more than is currently expected.

Such an improvement in the outlook for UK consumption is not currently priced into stock markets. UK equities should therefore benefit if retail sales do indeed start to improve.

When it comes to interest rate rises, the market is now pricing about a 55% probability that the Bank of England will raise rates again in May, and it is pricing a 40% probability that we will see at least two rate rises by the end of the year. If inflation falls faster than the Bank of England expects, then it might only deliver one rate rise this year, which would also be beneficial to consumers.

The current pessimism surrounding the outlook for the UK high street may seem excessive by the time we get to the end of the year. The halcyon days of the high street aren’t coming back but the outlook isn’t as bleak as it has recently seemed.

After what has felt like a long winter for the UK, there are likely to be sunnier times ahead.

Mike Bell is global market strategist at JPMorgan Asset Management