What Falling Inflation Means For Investors

Today, we have good news -- and bad news.

The good news? As the latest figures from the Office for National Statistics have highlighted, the rate of inflation fell to 2.8% last month, its lowest level for two and a half years.

And the bad news? The same, in short. Standing at 5.2% as recently as last September, inflation has almost halved in nine months. As with rapid rises in inflation, rapid falls are rarely unalloyed good news, either.

And that's doubly true for investors, as opposed to ordinary consumers.

Rising less steeply

First, let's look at exactly what has happened. We're talking inflation as measured by the Consumer Price Index, for a start.

That's the government's preferred measure, of course -- but one that also excludes a number of items of expenditure that have seen steeper price rises in recent times. Just ask any pensioner who keeps an eye on their budget and their bank balance.

That said, inflation as measured by the Retail Prices Index fell as well, to a 29-month low, to stand at 3.1%. So the two measures are telling the same story.

On the other hand, some of the major components of the fall in the CPI -- energy prices, fruit and vegetables -- attract either no VAT, or (for consumers) a reduced rate of VAT. So to that extent, the rise in VAT in early 2011 is something of a red herring.

Slumping demand

The real point, I think, is this.

Back in the autumn, economists and the Bank of England were predicting a fall in the rate of inflation. But what we've seen in the latest figures is a fall that is steeper than had been predicted.

Which clearly speaks to a weakening level of demand, both globally and nationally. Chris Williamson, chief economist at analysts Markit, puts it well:

"The drop in inflationary pressures is principally the result of very weak global demand, and an increasingly bleak looking economic outlook. Slower global growth has caused oil prices to fall by around one‑quarter since their peak earlier this year, with prices also falling for a wide variety of other commodities. This is not therefore a UK‑specific easing in price pressures we are seeing, with inflation rates also coming down in all major economies, notably the US, China and the eurozone."

Reading the runes

So for investors, what does it mean? And is it good news, or bad? The answer to that, in short, depends on what you're invested in, and the investment strategies that you are pursuing.

Here, in no particular order, is my round-up of what's likely to happen in the months ahead.

• Falling inflation makes further quantitative easing (QE) more likely. Most economists seem agreed on that. Will interest rates, currently 0.5%, be cut as well? It's been talked about, and the markets today are predicting that we'll actually see it by the end of the year.
• More QE is likely to be good news for share prices, but will see fixed income yields driven even lower. At some point, yields must start to rise -- heralding a fall in gilt prices -- but it seems that we're not there yet. In the meantime, those close to retirement will see annuity rates slump still further.
• Falling global demand, especially in commodities, will see the prices of resource shares driven lower. Income investors -- me included -- have been waiting for this, looking to lock in tasty dividend flows at decent yields. As it happens, the sector is also one of three profiled in this free Motley Fool report -- "Top Sectors Of 2012" -- which also pinpoints some of the leading yield candidates. Why not download a copy? It's free.
• Hard-pressed consumers might be feeling a little hard-pressed on hearing the latest news on the inflation front, but not by much. The fact is that net disposable incomes have been hit as badly as in the early 1980s, and consumer expenditure has been badly hit. Personally, I've been buying Tesco (LSE: TSCO) in recent weeks, and I'm expecting the retailer's battered share price to persist a little longer.
• On which note, inflation-linked corporate bonds have been a feature of the last year or so, as companies such as Tesco and National Grid (LSE: NG) have tapped private investors for cash. Although I considered buying them, I didn't, and they look even less attractive now. If inflation falls below 2% -- as IHS Insights' chief economist Howard Archer expects -- investors could be nursing capital losses if they sell before redemption.
• Finally, let's return to that theme of slowing economic activity. Technically, of course, the UK is already in recession. And if corporate earnings take a hit in the weeks ahead, the FTSE 100 (UKX) index of leading shares could well begin with a ‘4' -- ditto if we see a substantial worsening of the eurozone crisis, of course.

Uncertain times

So there we have it: good news, and bad news. Only one thing is clear: we are still in relatively uncharted territory. Bank rate of 0.25%? I never thought I'd see 0.5%, and 0.25% would be even more shocking.

But one investor able to look on such events with relative equanimity, though, is Neil Woodford -- simply because he's weathered choppy economic waters many times before. As our recent special free Motley Fool report -- "8 Shares Held By Britain's Super Investor" -- highlights, over the 15 years to 31 December 2011, he turned in a gain of 347%, versus the FTSE All-Share's 42% return.