Might falling inflation see these preference shares’ trajectories suddenly reverse?

On inflationary worries, prices of preference shares have been beaten down — and even-higher inflation will drive them still lower.

Question mark made up of pound symbols

Image source: Getty Images.

For most of the past year, inflation has been the economics risk of concern. This time last year, price inflation stood at just over 2% — although, as I wrote back then, forecasts had it doubling to around 4% by year end.

On the superior Consumer Price Index measure, it’s currently standing at 9.7% as of May, the latest month for which data is available (June’s figure comes out on 20 July.)  And on the Retail Price Index measure, it’s even higher — 13.4%.
 
Consumers are undoubtedly feeling the pain, and recent tax rises and rocketing fuel and electricity costs don’t help. Data from the Office for National Statistics shows that, collectively, we’re all spending less on food, are less inclined to eat out, putting off spending on things that can be delayed, and shopping online in search of keener prices.

Recession stalks the commodity markets

But take a look at the commodity markets, and there are signs of fears of a different situation: recession.
 
Simply put, given the level of economic activity, global commodity prices might be expected to be higher. Instead, demand is depressed, driving down prices. The suspicion: fearing recession, supply chains are de-stocking, opting for liquidity.
 
And of course, there are clear linkages between consumers feeling pain, and recessionary forces: over 60% of UK Gross Domestic Product (GDP), for instance, is consumer-led. So if consumers aren’t feeling flush — and are cutting back, as a result — then it’s logical to expect a resulting downward pressure on GDP.

Will there be a recession — particularly here in the UK? No one knows. GDP growth is anaemic, to be sure, but it’s still positive. And the next quarterly figures aren’t due until 20 September.

Diverging opinions

At which point, let’s introduce what we economists call an exogenous variable. And it’s one that could well decide the question.
 
It’s a fairly unusual one, too: the Conservative Party’s current leadership election, in which the UK’s MPs and around 100,000 mostly elderly, white, male, reasonably well-off members of the Conservative Party will decide who will become the next party leader, and hence the next prime minister.
 
In one corner we have Rishi Sunak, the former chancellor of the exchequer, and by all accounts one of the leading contenders — if not the leading contender. Basically, he wants to continue with tax and expenditure policies that he was pursuing until his resignation.
 
In the other corner, we have pretty much everybody else — united, it seems, by a common objective to cut taxes. Personal taxes, down. Corporation tax, down. Fuel taxes, down.
 
Who will win? And, having won, will they follow through with what they said on the campaign trail? Who knows?

But what it does mean is that one set of policies is likely to see inflation reduce, and the chances of recession increase — while the other set of policies will see money pumped into the economy from all those tax cuts, running the risk of driving inflation higher, but possibly seeing off the threat of recession.

Preference shares have higher inflation baked in

Why all this matters is that with even-higher inflation — or a recession — on the horizon, investors will want to position their portfolios accordingly.
 
I wrote last October about shares that might prove resilient in times of high inflation, and I’m not going to repeat myself here. The answer back then? REITs — coincidentally the subject of my last article here — looked like a good bet.
 
But here’s another interesting option, one that wasn’t available last October: fixed-income preference shares — shares such as National Westminster Bank PLC 9% Series non-cumulative preference shares (LSE: NWBD) or Lloyds Banking Group 9.25% non-cumulative irredeemable preference shares (LSE: LLPC).
 
If preference shares are new to you, you might want to read up on them: they’re not for novice investors. But suffice to say that there are plenty of preference shares out there — these are just two that are popular with the class of private investors who like to buy these things.
 
Why? Because preference shares are seen as offering a safer dividend than ordinary shares, and a dividend yield that is fixed — essentially as a percentage.

And also — very rarely — because preference shares (very occasionally) can have a decent capital upside.

And one of those occasions might just be hoving into view….

Is opportunity knocking?

Since last summer, LLPC is down 27%. NWBD is down a similar amount, 30%. Other preference shares are also similarly down.

And the reason isn’t difficult to see: inflation. Simply put, in inflationary times, preference shares’ fixed incomes become less attractive, for obvious reasons. So their prices fall. Right now, both LLPC and NWBD are yielding around 7%.

For a safer-than-average income, 7%-ish sounds attractive — at least, if you can stomach the risk of further price falls as inflation climbs ever-higher.

But let’s suppose that inflation doesn’t climb ever high. Let’s suppose that those tax cuts don’t materialise, and that recessionary forces do drive inflation sharply lower. In which case, the prices of preference shares could rise sharply higher.

How likely is such a scenario? You’ll have to ask those 100,000 members of the Conservative Party.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be considered so you should consider taking independent financial advice.

Malcolm has no position in any of the shares mentioned. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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