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Contrary to many expectations, the government’s first Budget didn’t cause massive inflation – at least, not yet. And the Lloyds Banking Group (LSE:LLOY) share price rose on Wednesday (15 January) as a result.
Shares in the UK’s biggest consumer bank jumped 6.3% on news that the rate of inflation in December was lower than expected. But how should investors react to this?
Inflation and interest rates
The latest inflation data from the Office for National Statistics (ONS) showed prices were 2.5% higher in December than a year earlier. And the FTSE 100 he rode in the news.
Lloyds was one of the biggest beneficiaries. But inflation increases the likelihood that interest rates will fall at the Bank of England’s next meeting in February.
This is not a good thing for banks in general – or Lloyds in particular. When rates are low, the margins banks receive on loans tend to contract, with weighted returns.
Inflation is terrible. And that’s why Lloyds’ share price has seen such a dramatic rise on the news that prices are not rising at the rate they were 12 months ago.
What inflation means for Lloyds
Inflation affects Lloyds in many ways. The first issue concerns its lending activities, where the bank’s income from loans is declining in real terms.
Another problem is about deposits. Savers also stand to gain a weaker return on their money, but this increases the risk that they will look elsewhere for better interest rates to offset this.
Third, the likelihood of borrowers defaulting on their loans is higher when rates rise. Household budgets are stretched and this makes it more difficult for people to repay their loans.
This may also measure the demand for new loans. Given the effects that inflation can have on your core banking activities, it’s probably not a big surprise to see the stock respond so well.
What should I do?
Investor sentiment has been all over the place recently when it comes to UK shares. Cash flowed out of UK equity funds at a record rate before the budget, but this changed after the announcement.
Similarly, concerns about inflation were a cause for concern. But share prices are rallying again as the latest news from the ONS shows that this is not as bad as initially feared.
When I buy stocks, I expect to own them during periods when inflation is high, low, or moderate. And I strongly suspect that the stock market volatility that has been causing prices to fluctuate has not yet ended.
As a result, I think buying shares in Lloyds – or any other company – just because the latest CPI number was lower than expected is very risky. So I look at this from the side.
Nothing to see here…
Inflation makes it more likely that Lloyds will earn a decent return on the loans it makes, so the latest news is undeniably good for shareholders. But this could change quickly.
The next update will come in February and if this is not so good, the effect on the stock market may reverse. So from a long-term perspective, I don’t think this is something we should pay too much attention to.
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