All change!
After spending most of the latter half of 2021 arguing that higher inflation was ‘transitory’, central bankers have pivoted to a ‘we’ll do whatever it takes’ stance on combatting high rates of inflation.
The rate of increase in prices in the UK (9.1%) and US (8.6%) has now risen to levels not seen since the 1970s. It is arguable that too much liquidity was pumped into the system during Covid which supercharged the subsequent recovery. At the same time global supply chains were under pressure (not helped by China’s zero-covid policy), labour supply has been tight, demand for oil and gas surged and in the UK we have seen ongoing Brexit issues. The subsequent higher inflation (5.4% in January 2022) may well have been transitory (supply and demand eventually even out), but the Russian invasion of Ukraine has ratcheted-up key commodity prices (oil, gas, food) even more. As these are costs that most people cannot avoid, high inflation has become a ’cost-of-living’ crisis.
Traditionally, Central banks have just a single weapon against inflation: interest rates (although they now have the ability to withdraw Quantitative Easing – known as Quantitative tightening – which effectively reduces the supply of money in the financial system). The US central bank (FOMC) has now increased rates by 1.5% in just three months to 1.75%, while the Bank of England has increased rates at each meeting for the last five months to 1.25%. To those of us who can remember interest rates in the seventies and eighties these rates still look low but to a generation of mortgagees, who have only known central bank rates of 0.25%-0.5% since the credit crunch in 2008/09, it’s a different story.
Whilst there is little that interest rates can do to impact on oil and gas prices or global wheat prices, central banks are more concerned about the second-round inflation effects: higher wage demands and consumers bringing forward spending in case things get more expensive. This is when inflation becomes entrenched and it can be very damaging. By raising interest rates, central banks effectively increase costs for businesses and consumers which reduces how much they can spend on buying things (goods/services). Eventually, as demand falls, inflation rates start to decline, in theory. The risk is that central banks go too far and falling demand becomes falling economic output and recession. These are the risks that the market is trying to come to terms with and which has led to the falls we have seen so far this year.
Key market returns in 2022 so far…..
| FTSE-100 | -3.13% |
| MSCI Far East | -9.48% |
| S&P500 | -13.82% |
| FTSE UK Gilts | -15.23% |
| MSCI Europe | -16.39% |
| Nasdaq | -24.47% |
Source: FE Analytics from 31.12.2021 to 17.06.2022
The (US) Nasdaq has been hardest hit of the major stockmarkets, due to its technology focus. Conversely, the (UK) FTSE 100 has held up relatively well. These are two sides of the same trade; when interest rates rise highly valued technology companies become less attractive while lowly valued, more traditional companies which pay a good dividend (which we have lots of in the UK) are more valuable to investors.
Unfortunately, bonds (as shown above by FTSE UK Gilts) have not been immune to the turbulence. The nemesis of a low-risk asset class such as bonds is sudden high inflation with concurrent steeply rising interest rates, as a bonds predictable cash-flows become less attractive. If inflation and interest rates move higher than the market believes then bonds will come under further pressure. Conversely, if inflation starts to peak and interest rate expectations decline, bonds could rally.
To put the recent falls into perspective, most markets (and investments) are still higher than they were before Covid struck which, given what the world has faced in the last few years, is a positive.
The key question that markets are grappling with is whether central banks can cool inflation without causing a recession; can they engineer what’s commonly known as a soft landing? There are signs that tighter monetary conditions are starting to reduce some inflationary pressures but it will take some time for this to be reflected in inflation rates – current price rises are already baked in. It is certainly possible that we could witness an economic slowdown or ‘technical recession’ which is classed as two consecutive quarters of negative economic output but this might not necessarily result in markets falling further; arguably some of this is already priced in. The Ukraine conflict will continue to affect prices and the outcome is uncertain but any sign of an end to the conflict would likely result in falling commodity prices.
All eyes will remain on inflation rates; if markets think that central banks have managed to cap inflation then markets could rally.
While it is not pleasant to see markets (and investment values) falling, these things happen, particularly when economic conditions change rapidly. Over the long-term equities offer a good hedge against higher rates of inflation for the simple reason that companies, generally, have the ability to raise prices to protect profits. Companies can either reinvest excess profits in the business (for further growth) or pay it out to shareholders (growing dividend) which are both attractive to investors.
Remaining stalwart to your long term plans, it is important to remain invested because as we have seen in the past, markets can change quickly. In the current market this could be a faster than expected inflation reduction or some form of resolution in Ukraine .
In case of emergency…….
Just a quick snippet this time, about emergency funds. A core tenet of financial planning has always been the benefit of retaining cash on deposit as an emergency fund. Having money you can easily access, and which will not fall in value, means you can always cover items of expenditure that just crop up (e.g. car maintenance, new fridge, large bills) but it also gives you the luxury of time; time to look for work if redundancy strikes or time to allow pensions or investment to recover in the event of a market crash or something like a global pandemic.
There are no right or wrong amounts for an emergency fund but for those who work, I would normally recommend at least 3-6 months net income. For those who are retired, and have less ability to replace depleted assets, then 1-2 years annual expenditure provides a good buffer against the unknown.
It has not been easy over the last 10 years to commit large sums into cash because of the absence of returns. However, rising interest rates are one silver lining of the current situation as cash returns become more meaningful. But only for necessary funds; over the long-term cash is steadily eroded by inflation. Even if cash rates rise to 3%, with inflation at 9% the spending power of cash reduces by 6% per annum.