Article written by Iain Lightfoot, Managing Director, Armstrong Watson Financial Planning and Wealth Management and Richard Cole, Fund Manager at Future Money Ltd. Building on these articles, Iain and Richard have also recently recorded a series of Quarterly Webinar Updates, offering an overview of the investment markets and looking at each of the Future Money solutions in detail. The next webinar will be hosted on Friday 5th November, please sign up to watch it here.
As regular readers of our articles will know, inflation has been a favoured topic over recent months. With covid seemingly contained by the vaccination effort, markets are now focusing on the factors which will drive a change in direction from global policymakers, i.e. away from stimulus and towards calming measures. Such topics remain of key concern, and especially so with the recent announcement that US inflation has once again beaten expectations, yet one area within this topic which we have not yet discussed and which has the potential to hurt markets is the possibility of stagflation.
Inflation occurs as the result of too much demand chasing too few resources. When this mismatch results from buoyant growth, inflation can be a healthy side-effect of a well-functioning economy. Yet, when inflation emerges from problems delivering supply in the face of only tepid demand, then prices can rise despite a stagnant economy. This latter scenario is stagflation.
While in and of itself stagflation is a sign of a sub-par economy, it can also become a cause of further deterioration. A traditional response of central banks facing inflation is to raise interest rates. This raises the cost of borrowing so that individuals and corporations are more inclined to put money in the bank and less likely to borrow to consume or invest, which then weakens demand and so reduces price pressure, thus reducing inflation. Yet, in a stagflationary environment where demand is already weak, cooling the economy further through higher interest rates is more likely to lead towards recession and so can be an ominous sign for investors.
In the current environment, there are a number of signs suggesting that stagflation may emerge, but at this stage it appears to be a possibility rather than a probability. Supply is facing a number of concerning constraints, with blocked shipping ports, HGV driver shortages and escalating energy prices all leading to higher costs in getting products on shelves. Yet demand is currently strong thanks to the huge volumes of stimulus in the system, and so a high cost, high demand balance is in play. However, with central banks now taking tentative steps towards tightening and with government policy also becoming less accommodative, a fall in demand over the next six months would not be a shock and so with it we could soon face stagflationary pressures.
This is therefore likely to lead to times when markets take a pessimistic view of the future, and there have been days over recent weeks where this mood has taken hold. Yet, in our opinion it is what happens beyond this short term horizon which is likely to be most important in determining the path of the global economy. While the removal of crisis era stimulus is expected to create difficulties, supply-side bottlenecks are unlikely to persist over the longer term and so a new equilibrium is likely to be found as 2022 progresses. At this point the economy is likely to be benefitting from the latent effects of the pandemic support (low unemployment and a healthy banking system) and also from government policy seeking to engender productivity. In this scenario, inflation may well remain above target levels, but with growth also present a healthy economic scenario would be achieved.
Of course this projection may turn out to be overly optimistic and in which case markets would likely experience a challenging time. As such, closely following the driving forces in inflation figures will be important. Yet, with central bankers highly attuned to this risk and with strong economic fundamentals currently in place, we do believe we are on course for inflation, but that of the growth variety and not of the stag.
Our philosophy is that no one can predict the peaks and troughs of financial markets with any accuracy and it has always been extraordinarily difficult to time when the best (peaks) and worst (troughs) are. Timing the stock market is extremely difficult, so we believe it is best avoided. Volatility is a part of investing which is why we always take time to understand how much risk any client is prepared to take before investing. We also generally believe in the benefit of diversification of assets to help manage some of the extremes of the markets. Taking a diversified multi-asset approach means that some assets can fair better in different market conditions as they are more defensive assets such as bonds, whereas during periods of growth equities tend to fair better.
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A key aspect of our investment philosophy is that it is time in the market not timing the market, which is usually the best approach.
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Please note that the contents are based on the author’s opinion and are not intended as investment advice. Past performance is not a reliable indicator of future performance. The value of investments and the income derived from them can fall as well as rise and investors may get back less than they invested.
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