The scourge of inflation and its consequences
Sometimes it seems that economic surprises are segmented and unrelated, but of course that is not the case. One of the most plausible cases put forward for the collapse of Silicon Valley Bank and the subsequent strain on Credit Suisse was that this in part was caused by the decline in the value of the banks’ bond holdings, which had formed a substantial part of their capital reserves. That decline in bond valuations ties closely in with one of the major economic storylines of the last 18 months – surging inflation and a subsequent increase in interest rates across the US and Europe.
As inflation started to rise, the initial reaction of both central banks and markets was to assume it would return to previous low levels once the impact of Covid and the war in Ukraine washed through the system.
We have been doubtful about this optimistic scenario over the last couple of years. For a start, many of the factors keeping inflation low over the past 30 years no longer appear to apply: the transfer of manufacturing to Asia may have run its course, as has the reduction in trade union power. And indeed, through 2022, the language of central banks changed radically: from inflation being a short-term blip, or “transitory” in nature, to its potential as a longer-term scourge that needed to be addressed through central bank action.
We have been surprised at the resilience of economies and markets under the pressures of the last three years. The recovery from Covid has been stronger than expected and has been maintained despite rising inflation and interest rates. Part of the explanation for this may be the rise in the money supply. Since Covid, we have seen a very sharp increase in the money supply, particularly in the US. While this has reversed sharply in the last few months, the recent bank problems may force central banks to pump more money into the system, at least over the short term. We will be keeping a close watch on money supply measures and their potential to impact the price of risk assets: looser money supply measures means more lending to riskier firms and greater risk taking both by banks and more generally.
Bond performance over past year
All bonds 10+ years, 04/04/2022 – 04/04/2023, local pricing
The German 10-year yield has oscillated between 2 and 2.5 per cent year to date: very different to the position in 2019 through 2021 where yields remained stubbornly below zero. The comparable US range has been 3.5 to 4 per cent.
In absolute terms, yields look more tempting than they have done, but in real terms, bonds are struggling to provide positive returns. The US 52-week Treasury currently yields 4.6 per cent, with the most recent annual inflation figure coming in at 6 per cent – although the Federal Reserve’s current projection for 2023 core inflation is 3.6 per cent. 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
04/04/2022 – 04/04/2023, local pricing
Equity markets had a strong January as many believed the interest rate cycle had reached its peak and would stabilise before starting to fall. February bought a more pessimistic approach as it became clear that central banks were still intent on raising rates to combat inflation, while March saw more concern driven by banking nervousness.
This history can be seen in the S&P 500 indexes fortunes so far this year, rising 6 per cent in January, then slipping 4.5 per cent to mid-March before recovering as the Fed and the Swiss central bank appeared to pump sufficient funds into the banking sector to appease both savers and shareholders.
Having held value better than most asset classes through 2022, there has recently been some downward pressure on European property values. This is likely down to the ripple effects of the war in Ukraine, ongoing energy concerns and a lagging impact from Covid related factors. In the short term, rising interest rates and lower liquidity are also likely to weigh on prices across the sector and, with this likely to persist through 2023, we would be cautious on property for now, but expect that buying opportunities may arise later in the year for those less driven by liquidity needs.
Commodity performance over past year against equities
04/04/2022 – 04/04/2023, US dollars
Commodity prices have risen in the past couple of years but have generally been declining over the past 9 months, with the price of Brent crude oil sliding from over $120 to near $75. We continue to believe that the switch to renewables will benefit the longer-term prospects for hard commodities such as nickel and copper, but the volatility of these markets make them attractive only to serious risk takers, or very long-term investors without interim valuation pressures.
Hedge fund performance over past year against equities
04/04/2022 – 04/04/2023, 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.
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.
Credit (Senior loans, High Yield & Emerging Market Debt)
We remain positive on credit as a diversifying strategic allocation within portfolios, and they are currently offering a relatively high and attractive premium over cash. Given the extend of the recent upward movements in bond yields and the current stage in the economic cycle, we would have a tactical preference for Emerging Market Debt over High Yield Debt or Senior Loans at this time.