Does UK equity income sector work amid periods of high inflation?

No one likes nasty surprises, and investors might quite rightly say they have had more than their fair share of late, but that is exactly what April’s inflation data delivered. 

Headline inflation fell, but by less than expected, dropping to 8.7 per cent in April from 10.1 per cent in March, compared with consensus forecasts of 8.2 per cent. While lower energy prices dragged the inflation rate down, high food prices kept it up.

The biggest worry is that core inflation is on the march, rising to 6.8 per cent from 6.2 per cent. And services inflation, the Bank of England’s preferred measure of underlying inflation, jumped to 6.9 per cent from 6.6 per cent, above the BoE’s forecast of 6.7 per cent.

Off the back of this, the expectation is that the central bank will hike rates again in June, by another 0.25 per cent. After so many increases, cash Isas are back on the menu. But investors thinking about holding cash, and still losing out to inflation, should not ignore the potential of UK equity income funds if they do not need as much liquidity.

Attractive option

Yes, UK equity income funds have been out of favour. But all are yielding more than the 3.2 per cent offered by the best easy-access Isa (according to Moneyfacts and Morningstar data respectively), and more than half of all UK equity income funds (55 per cent) are yielding more than the 4.25 per cent offered by the best fixed rate Isa.

Although inflation is expected to begin to ease, in an environment where it remains stubbornly high, UK equity income funds present an attractive option because of the additional contribution dividends can make to total returns. 

With dividends reinvested, the average UK equity income fund has returned 5 per cent a year over the past 10 years. That is significantly more than cash, even if we compare it with current rates. 

At the same time, there is also a valuation opportunity in the sector versus not just cash but other types of asset classes.

“It’s no secret UK equities have been out of favour since the EU referendum, and the fallout from the Woodford scandal hasn’t helped the wider UK equity income sector,” says IFSL Marlborough Multi Cap Income manager Siddarth Chand Lall. 

For an already unloved sector, macro shocks such as Russia’s invasion of Ukraine and last year’s “mini” Budget have caused further uncertainty, but this has had a particular impact on small and mid-cap stocks of the type Chand Lall likes.