Health concerns dominate FTSE trade

On Tuesday 14^th February the Office for National Statistics is scheduled to release UK CPI data for January. The market expects the annual rate to rise to 1.9%, just shy of the Bank of England’s 2% inflation target.

Interestingly, the monthly CPI data is expected to show a 0.5% decline for January, but this is likely to be a one off, largely due to a drop in gas prices. Don’t be fooled by the monthly inflation data, UK consumer prices are set to rise over the course of this year, and could peak at 3% by the end of this year.

It’s the pace of price rises that matters…

While the market has been well-prepared for higher prices in the UK due to rising energy prices –  oil prices have risen nearly 20% since early December –  and the effects of 2016’s sharp drop in the pound starting to impact price pressures, this month’s data is a key gauge of how quickly price pressures are building.

Also released alongside CPI data is UK producer prices and the retail price index (RPI). The RPI, excluding mortgage repayments, is expected to rise from 2.7% to 3.1%, its highest level since 2013. This is worth watching, as higher than expected retail prices could suggest that CPI may peak above 3% in the coming months. Producer prices are also worth watching, with annual input prices expected to rise to 18.5%, its fastest rate since 2008.

The extent of the market reaction will be driven by a data shock, so if price rises are roughly in line with market expectations for last month then we wouldn’t expect to see a big market reaction. However, if prices are higher or lower than expected, then markets are likely to be extremely volatile.

The impact if CPI is higher than expected:

If prices jump above the BOE’s target rate of 2% in January, this could cause a major reaction in the pound, the UK bond market, and it may also hit the share price of some UK retailers. Expectations for UK rate hikes have been scaled back in the past two weeks, as the market reassess the BOE’s willingness to hike interest rates as political and Brexit uncertainty continue to threaten growth. There is also concern that one of the BOE’s more “hawkish” members, Kate Forbes, is leaving the Bank in June, which could tip the balance in favour of the “dovish” members. However, if price pressures are rising at a significantly faster rate than expected, then rate hike expectations could be brought forward, which could see upward pressure on UK bond yields and thus GBP/USD, which could trade back above 1.25, towards the 1.27 highs from earlier this month.

A stronger reading could also impact the UK retailers. One of the big macro themes for 2017 is rising price pressures choking off consumption later this year. The UK’s biggest retailers include the top supermarkets, John Lewis, M&S, Home Retail, Boots and Kingfisher, below we show how two UK retailers could be impacted from faster than expected CPI data on Tuesday.

Two retailers to watch out for:

The UK’s largest retailer, Tesco, has seen its share price come under pressure this year, its share price is already down by nearly 5%. Rising inflation could weigh further on Tesco’s margins, as it may encourage even more discounting and squeeze consumption later this year. If CPI is stronger than expected on Tuesday, then it could trigger further downside in Tesco’s share price, potentially back to the 187p low from 24^th January. This could also be exacerbated by weak UK retail sales due for release on Friday.

Marks & Spencer is also worth watching, as its share price has been trading sideways since September. Aside from price pressures and stress on the consumer, the market has been disappointed with M&S’s strategy review and there doesn’t seem to be a simple solution to the retailer’s long-held problems. M&S is also pushing further into the competitive food-retail market as part of its turnaround strategy, due to this rising prices could hurt sales and margins even more in the coming months. Thus, we wouldn’t be surprised to see some potential weakness in M&S’s share price on the back of stronger CPI; 322p, the low from November, is key support in the medium-term.

What if price pressures are weaker than expected?

Although we view a weaker than expected CPI reading as a low probability event, it could have a big impact if it does happen. We would expect an immediate scaling back of rate hike expectations, potentially into 2019, which could drive GBP/USD back towards 1.22. It would also be good news for the retailers we mentioned above, as weaker than expected price pressures could sustain the UK’s consumption-led growth for some time longer.

Overall, this data is worth watching closely on Tuesday, since a larger or smaller reading relative to expectations may trigger a decent market reaction.