Inflation – an upward spiral
Francis Fukuyama famously talked about the end of history before the world served up 9/11, the global financial crisis and now the re-emergence of the Cold War. Similarly, there are those holding their heads low who predicted that inflation in the Western world was a thing of the past. As we now know, it’s not. And it’s getting worse.
We’ve had a notion for quite some time that inflation had returned, but the view on its magnitude has changed rapidly during the year. Central bankers and policymakers had originally thought that inflation was caused simply by a squeeze on supply pushing up prices – energy prices in particular. They now understand this present bout of inflation to be far more persistent and pernicious than previously thought. Late September saw a calcification of efforts on this. The Federal Reserve announced on 21 September that it was raising US rates by 0.75 percentage points to the highest level in almost 15 years. A day later the Bank of England raised interest rates to a 14-year high of 2.25% while the European Central Bank said earlier in the week that it may need to raise interest rates to a level that will cool down the economy. In other words, if you weren’t aware how seriously policymakers were taking inflation at the start of that week, you could definitely not say the same by the end of it.
How have we got to this point? Driving a large part of the inflationary pressure was the massive overstimulation of the economies that took place during the pandemic. In parallel, one of the lids on inflation in recent decades has been China’s constant supply of cheap goods and materials, something that’s a lot less certain now that a trade war looms between the West and the world’s second-largest economy.
Central banks are now taking the prospect so seriously that they’re indicating a recession is the price worth paying to keep a lid on rising prices. Should rate increases work, the rate of inflation might start to slow sometime in the first half of next year. As a result, Central Bank rate activity should decelerate around the same time. The US and UK may need more prolonged action because of the relative overheating of the US economy and the playout from huge UK tax handouts. In any event, it appears likely that the spectre of inflation will be with us for some time yet, with significant effect on the value of securities.
Bond performance over past year
All bonds 10+ years, 29/09/2021 – 29/09/2022, local pricing
Bond prices are so intrinsically linked to inflation and interest rates, that, not surprisingly, there have been significant moves in yields. The US 10-year Treasury yield, the global benchmark, has risen to 3.8%, a staggering rise when you consider that it was sitting around 0.7% just two years ago. The German 10-year Bund yield, the main debt security in Europe, has likewise had a remarkable transformation, positioned just above 2%. Consider that it had spent 2020 and 2021 in negative territory – in other words people were prepared to pay the equivalent of an annual fee to hold the bond instead of getting any interest on it.
The fate of the UK’s 10-year gilt yield is particularly marked. New Prime Minister Liz Truss has gone for broke with a £45 billion tax giveaway attempting to jumpstart the UK economy. Combined with a costly energy price guarantee, borrowing requirements will soar. Not surprisingly the yield has rocketed from under 2% in mid-August to over 4% as investors require higher payments to be lured into an increasingly shaky fiscal framework.
Equity performance over past year
29/09/2021 – 29/09/2022, local pricing
If the movement of bonds has been easy to explain, the performance of equities has been more nuanced. There is a collision of various factors to consider – rising inflation can drive investors to equities as dividends are seen to be somewhat inflation-proofed. Working against this, rising interest rates can dampen economic growth, lowering the potential of stock market returns. With the Federal Reserve predicting US growth of just 0.2% this year, that’s already weighing on companies’ estimated earnings. Reuters reported on 22 September that while the S&P 500’s third-quarter earnings growth is set to come in at 5%, excluding energy brings that right down to -1.7%, showing that dent in corporate profits and the parallel significant rise in earnings at energy companies.
Overall, equity markets are down somewhat but are still relatively high on a multi-year examination. The US benchmark S&P 500 index has slid about a fifth from the start of the year, but is still up about 50% on a five-year view. That continued strength may be explained by lack of investment opportunities elsewhere and we can expect more volatility over the next 12 months.
Property values in contrast have been reasonably stable and, in some cases, rising. We are still seeing the Covid effect on retail and city centre properties where there has been a shift in work patterns – many workers have not yet returned to a five-day office stint and that’s impacting businesses used to serving a consistently large and reliable cohort of workers. We do see opportunities in the consequent benefits for online trading in warehouses and the like. We have also seen that some institutional property funds are allocating money to residential real estate, a trend which we find interesting but as yet to prove successful. Property does provide some degree of protection against inflation and therefore where appropriate we suggest retaining holdings.
Commodity performance over past year against equities
29/09/2021 – 29/09/2022, US dollars
Not surprisingly any considerations in commodities have been dominated by movements in energy markets. Natural gas prices have more than tripled in the past year on the back of supply concerns related to the Ukraine war, and that has had a ripple effect through other energy markets. The spot price for crude oil climbed from about US$77 a barrel at the start of the year to reach a high of US$124 a barrel in early March. Since then, it has slid back to about US$86 a barrel.
We have pointed out in the past how the switch to renewables and investment in infrastructure could benefit commodities such as nickel and copper. However, the increased economic uncertainty has weighed on those prices, with copper sliding by about a third since March.
Hedge fund performance over past year against equities
29/09/2021 – 29/09/2022, US dollars, hedge funds priced monthly
We still believe that hedge funds may make an appropriate investment as part of an overall balanced portfolio because of their defensive qualities in a market reversal. While overall returns are not expected to keep track with equities over a cycle, their value is evident at times of high volatility and market falls such as we have seen this year.
Sharp movements in currencies in recent months have given some opportunities for gains (and losses). These funds continue to be a useful diversifier.
Global Tactical Asset Allocation Funds
These funds provide better diversification benefits because of their broader investment universe. Recent experience has been quite good; however, performance can vary considerably between those performing well, and those that are struggling to deliver. For this reason, many have still to really prove their worth and having a good understanding of what you expect to get for the fee you are paying is key to investing in this asset class.
Another diversifier, these loans are illiquid and have some credit risk, which is the basis of the return over cash that investors receive. While the risk of default on the underlying investments increases during a downturn, their floating rate nature is an attractive characteristic in times of rising interest rates like now.