Inflation – what next?
Inflation, rising prices bringing a decline in the value of money, is an inherent part of the human economic condition. It’s a complex issue with which to grapple – too little of it and the economy goes into deep-freeze, too much of it and it destroys the value of the assets that we hold and upon which much economic activity depends. Society employs policymakers to try and bring some stability and certainty to the value of money, but central bankers are not blessed with clairvoyance, and can only act on the information that they have at present and with a limited number of tools.
This is a roundabout way of saying that trying to predict inflation is nigh on impossible. Those of us old enough to remember will have their own stories about the rocketing inflation of the 70s and early 80s. Several decades of super-low inflation brought complacency to many but a return has seemed more probable in recent years: some suggested that quantitative easing after 2008 would be the trigger, others that the massive government intervention during the Covid pandemic would set prices spiralling.
Whatever the underlying cause, this year inflation took off with a vengeance. In the US the annual rate reached a peak of 9.1 per cent in June, while in Europe it climbed even higher, with Eurozone inflation reaching 10.6 per cent and UK inflation reaching 11.1 per cent in October. It appears that we may just have reached the top of the cycle, with markets predicting that rates will fall to about half of what they are present – indeed in the US the rate slipped to 7.1 per cent in November. How quickly it will now reduce is dependent on both central bank policy and more general economic factors. To slow rising prices, central banks will have to dampen economic activity by raising interest rates, thereby slowing the supply of money. Central banks have a difficult balancing act to slow the economy sufficiently to quell inflation without driving significant recession.
There’s also a balancing act to be done from the other perspective. The concern in Europe in recent years has been that inflation was too low and was slowing economic growth. However, our central expectation now is that inflation should settle down to somewhere between 2 and 4 per cent, a level that shouldn’t overly intrude on long-term growth prospects, but with the proviso that a major escalation in the Ukrainian war may keep inflation higher for longer.
It’s worth noting here the recent reminder of the importance of economic management provided by the short-lived government of Liz Truss. Part of the imbalance in economies is due to massive injections of government spending during and after the Covid crisis. Without plans on how to deal with the resulting pressure on finances, either through higher taxes, spending cuts or organised borrowing, countries will be heavily punished by bond markets, as the UK discovered in September when its government debt yield reached a 20-year high.
Bond performance over past year
All bonds 10+ years, 19/12/2021 – 19/12/2022, local pricing
As we have stressed beforehand, bond prices are intrinsically linked to inflation and interest rates. It follows that there were significant movements in bond prices and yields over the past year. The benchmark US 10-year yield climbed from below 1 per cent at the start of 2022, to 2 per cent in March, 3 per cent in June and reached 4.2 per cent in October. Even the German 10-year yield, in negative territory at the start of the year, reached a 2022 high of almost 2.4 per cent just over a month ago.
The US yield has now slipped back slightly to around 3.5 per cent on the back of reined-in inflation forecasts but increased yields have, for the first time in many years, made a case for investing in long bonds that’s not driven purely by matching.
Equity performance over past year
19/12/2021 – 19/12/2022, local pricing
Equities have had an up-and-down year – mainly down. The real surprise though is, given all the headwinds in the world, from inflation through to war through to challenging global supply chains, that they haven’t fallen further, trading in a range of about 5 to 25 per cent below the very high levels at end 2021.
The US benchmark S&P 500 index dipped 20 per cent over the year to date, but it hasn’t been a straight decline, climbing over 10 per cent from mid-June to mid- August. Indeed, we are slightly flummoxed by the relative strength of equity markets from the middle of the year – it’s not as if the economic or inflationary outlook has improved in any meaningful way.
Within markets there are obviously some sectors that have done better than others. Technology has been particularly challenged for well-flagged reasons related to increased regulation and a lower reliance on virtual communications following the end of the Covid pandemic. The technology heavy Nasdaq index has shed 33 per cent this year. Conversely, and not surprisingly, energy stocks have been doing rather well, with the S&P Oil and Gas Exploration and Production Select Industry index climbing by almost a third since the start of January.
We remain neutral on global equities, and while the uncertainty in the economic and geo-political environment is likely to lead to high volatility continuing, we are advising clients to consider significant falls in markets as re-balancing, or buying, opportunities.
European property has seen some decline in value recently, but has not fallen anything like as much as equities or bonds months. Our expectation is that the ripple effects of the war in Ukraine, ongoing energy concerns, and rising interest rates may result in some further downward pressure on property prices over the next year. In the short term, liquidity is also having an effect on the sector. While this is likely to persist into 2023, buying opportunities may become apparent in the latter part of the year, for those less driven by liquidity needs.
Commodity performance over past year against equities
19/12/2021 – 19/12/2022, US dollars
Commodity prices have risen in the past couple of years but there have been sharp declines during the year, with the price of Brent crude oil sliding from over $125 in March to near $75 as of 19 December. We continue to believe that the switch to renewables will benefit the longer-term prospects for hard commodities such as nickel and copper.
Hedge fund performance over past year against equities
19/12/2021 – 19/12/2022, US dollars, hedge funds priced monthly
We still believe that hedge funds may make an appropriate investment because of their defensive qualities in a market reversal. Overall returns are not expected to keep track with equities over a cycle, but their value is evident at times of high volatility and market falls such as we have seen this year.
These funds can return gains or losses depending on the relative strength or otherwise of the currencies they hold but they are useful as a diversifier because of the relative independence from other securities.
Global Tactical Asset Allocation Funds
Recent performance of these funds has been relatively positive and because of the very wide range of investments they hold, they provide a useful diversification.
Again, useful for the diversification, these floating-rate sub-investment grade securities offer a premium over cash, and their floating rate nature has allowed them to deliver less negative returns during this year’s rising interest rate environment than long duration fixed income securities.