Article written by Iain Lightfoot, Managing Director, Armstrong Watson Financial Planning and Wealth Management and Richard Cole, Fund Manager at Future Money Ltd. Iain and Richard also host regular webinars called “Making Sense of Markets” where they discuss the factors affecting economies and markets. Our latest webinar was held on 6th May, please click here to watch the recording. Our next scheduled webinar is on 5th August.
Our philosophy is to utilise active management solutions as we believe in the skill and judgment of professional fund managers to choose where to invest and have the ability to manage the underlying assets according to economic and market conditions.
Below we comment on a range factors including continuing rising inflation, this week’s increases to interest rates and the challenges they pose to investment markets.
Inflation in the UK, as measured by the Consumer Prices Index, has reached 9%, the highest level since 1982. The previous month’s reading was 7%, with three quarters of the month-on-month jump due to the increase in the energy price cap in April. The additional increase in these figures now means that the UK has the highest inflation rate in the G7. While the figure was broadly in line with market expectations, and is no surprise given the Bank of England’s recent comments on projected inflation, the figure still has the ability to raise eyebrows. The Bank expected that inflation is likely to peak at above 10% later this year, following the October review of the energy price cap.
For the fifth meeting in a row the Bank of England has raised interest rates, taking the benchmark lending level from 1% to 1.25%. More rate rises are expected in the coming months and the rate of increase may yet quicken. A minority of the Bank’s Monetary Policy Committee voted for a 0.5% raise this time, but that could well turn into a majority in future meetings. A more aggressive tightening of monetary policy conditions is needed as inflation continues to accelerate in pace, but also to broaden in its presence.
In summer 2021, central bankers repeatedly claimed that higher inflation was ‘transitory’ and that it would quickly fade as the bounce in prices related to covid reopening washed through the 12 month numbers. Since then, however, inflation has already risen well beyond previous expectations and continues to experience upward revisions in future projections. The Bank now expects UK inflation to peak at around 11% late this year (10% was the previous forecast).
High inflation can still be linked to covid factors such as disturbed supply chains (especially with China still pursuing its ‘Zero-covid’ approach and the subsequent lockdowns), but it is now also caused by a range of other factors. Russia’s invasion of Ukraine is the single biggest contributor, with the surge in price of oil, gas and other commodities adding to the costs of energy, agriculture, manufacturing and transport. Brexit is also playing a part in the UK’s rising price level, with disrupted trade with our nearest business partners adding to price friction. Finally, there is also what can perhaps be considered ‘good’ inflation, in that prices are rising across a broader range of sectors as we have an economy which is actually still very buoyant, despite the problems out there. Demand remains high as both corporate and personal balance sheets remain healthy and the labour market shows few signs of distress.
Higher inflation is therefore no longer an issue that can be brushed aside, with central banks keen to maintain credibility given their targets to maintain rising prices to 2%. More forceful action is therefore no surprise and should be expected to continue over the coming months.
The UK is not alone in raising rates. The Swiss Central Bank increased interest rates for the first time in 15 years this week. The European Central Bank is expected to follow suit in the coming months and the US Federal Reserve is surging ahead with tighter policy. US inflation fell from March to April this year and consequently the question was being raised of whether the worst was over for the US and so only moderate further interest rate hikes would be required. Yet, when the May inflation figure was released last week, it showed a surprise increase. This was taken as a sign that the Fed would need to act more aggressively and sure enough with their rate decision this week, they hiked the lending rate by 0.75%. Such a large move had been expected (0.25% is typically the default size of movement), yet it still had a wow factor to it, showing how far the US and by extension the global economy has changed from the ‘lower for longer’ environment which dominated from the global financial crisis until the pandemic.
Higher interest rates means the global economy faces significant challenges. With the aim of controlling inflation levels, economic output must be supressed. Higher inflation requires higher interest rates and this means economic growth will be more impacted. Recession is therefore more likely. Investment markets, therefore, are fearful. While US equities initially rallied after their rate decision, as the comments accompanying the announcement suggested that repeated 0.75% hikes were less likely than some had assumed, in the subsequent session the S&P 500 fell by 3.25%. The tech focused Nasdaq index, fared worse, falling 4.08%. UK and European equity markets also fell by around 3%.
Bond markets also experienced volatility, with investors tussling over the contrasting forces for fixed income securities in the current environment. On the one hand bonds typically provide defensive characteristics at times of economic stress, yet on the other, in times of higher inflation, their fixed returns lose value. Since inflation became more of an issue for markets during winter, the latter argument has been winning, with the FTSE UK Gilt All Stock index falling by c. 19% since 7th December 2021. Over the same time period the S&P 500 is down c. 20% (in USD terms) yet the FTSE 100 is down just c. 3% (source: Alpha Terminal). With gilts typically considered a ‘defensive’ asset, this illustrates well that when inflation is high, characteristics can change dramatically. This also shows that yesterday’s winners can quickly turn into today’s losers. For much of recent years, US equities have outperformed their UK peers as the high concentration in fast growing technology companies have garnered huge support and high prices, while the more ‘boring’ sectors which dominate the UK (banks, energy, commodities) have languished. Yet, when inflation and interest rates are higher, prospects are changed and the previously unloved can quickly move back into prominence.
In the investment portfolios managed by Future Money we currently maintain overweight allocations to UK equities, underweight positions in the US and have lower than average sensitivity to interest rate movements in our bond positions, meaning that the portfolios are benefitting on a relative basis in this period of higher inflation.
Investment markets are in a difficult position currently with the prospects of a slowing economy. This is likely to lead to continued volatility and potential losses over the coming months as economies slow. Yet, over the medium term we continue to believe that any economic slowdown will be mild relative to previous contractions. Despite the recent adjustments to inflation expectations, price levels are still predicted to calm significantly throughout 2023 and unemployment is not expected to increase by large amounts. Therefore there is likely to be the prospects for a relatively quick return to a more positive economy and so one which is also likely to reward investment markets.
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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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.