Economic Performance & Outlook
Inflation – here for longer than originally expected?
If there was one key backdrop to the economic situation that we find ourselves in at the moment it would have to be centred on inflation, the phenomenon of rising prices and the declining value of money. It’s generally accepted that a little bit of inflation is a good thing – indeed deflation or falling asset prices can be disastrous in delaying purchases that eventually stunt the growth of an economy. Higher inflation however shreds the value of savings and causes so much uncertainty that economic progress is stifled.
The past 18 months has seen a resurgence of higher inflation, and a parallel determination on the part of central banks to bring it under control. The initial bout may have been due to surging energy prices on the back of Russia’s invasion of Ukraine, together with food-related inflation driven by conflict-related restrictions on grain exports. Early pressures on energy are now very much in the past, yet inflation – albeit falling – is very much still with us.
A key driver is the higher wages negotiated by staff benefitting from very tight labour markets. This is particularly the case in the US, perhaps deriving from the number of people who left work during the pandemic and have decided not to return.
Whatever the explanation, it seems that we will be dealing with inflation for longer than we had expected. This will vary from country to country: the US seems to be seeing some pressure rescinding, while in the UK it’s getting worse, most certainly due to Brexit-based restrictions on imports and a tight labour market exacerbated by immigration controls. Policymakers have recognised that this spell may be getting entrenched and therefore aggressive increases in interest rates may continue to be necessary.
The paradox, however, is that equity markets are not pricing much of this in, having remained healthily buoyant over the past few months, even as the prospect of increased rates makes some kind of downturn more likely.
Bond performance over past year
All bonds 10+ years, 16/06/2022 – 16/06/2023, local pricing
A key trait of the multi-decade low inflationary environment we are emerging from is that it allowed borrowing rates remain low, with many central banks able to borrow at near zero or even at negative rates. Not so more recently. As inflation began to rise, the market initially expected the impact to be short term, and short-dated debt was most seriously impacted. Now that inflation looks more entrenched, reverberations have spread to longer-term fixed-income securities. Ten-year yields now stand close to 4 per cent in the US, up from under 2 per cent in January 2022. In Germany they’re at 2.5 per cent after being negative 18 months ago. In the UK they’ve shot up to 4.4 per cent on the inflation outlook and short-term yields have even climbed beyond those witnessed during Liz Truss’s disastrous administration.
What does this mean for investors? While those yields still sit below current inflation levels, these bonds may well make reasonable investments over the longer term. Central banks do appear to be winning the battle against inflation, with the expectations that rates in some countries may be reaching their peak
Equity performance over past year
16/06/2022 – 16/06/2023, local pricing
The tried and tested way to tackle inflation is by increasing interest rates with one purpose in mind – to slow down economic activity and therefore put downward pressure on prices. That however is not good news for companies – a slowing economy normally means lower sales, feeding through to lower profits which should in theory put a dent in share valuations. Stock markets, however, do not appear to have absorbed economic theory. Maybe some investors feel that the negative case is oversold and that central banks might be able to hold back inflation while also not seriously slowing the economy. Some sectors, such as technology, have been performing extremely well, partly due to well flagged instances of opportunities in artificial intelligence.
The bottom line is that so far this year the Standard & Poor’s 500 index has climbed 15 per cent while the technology focused Nasdaq Composite has rocketed over 30 per cent. We believe stocks are likely overvalued at the moment and that some corrections may be coming in the near future.
Property may still be affected by the ongoing after-effects of the Covid pandemic as people work more from home, though we well know there is a shortage of supply in the Irish residential space, boosting this sub-sector. While prices may also be dampened by rising interest rates, we still believe European property, with longer cycles, provides useful diversification to equities.
Commodity performance over past year against equities
16/06/2022 – 16/06/2023, US dollars
While the price of commodities surged during 2022, they have declined somewhat in the present year as pressure on energy fell, partly due to the particularly mild winter experienced in Europe – the price of oil has slid about 7 per cent this year. Copper prices have dropped about 9 per cent from their January peak, while also climbing the same percentage from their 2023 nadir in the last month. Given the increased volatility we have seen in these securities, we think that investments in some areas may be left to more serious risktakers than ourselves.
Hedge fund performance over past year against equities
16/06/2022 – 16/06/2023, US dollars, hedge funds priced monthly
Hedge funds can make an appropriate investment because of their defensive qualities in a market reversal.
These funds have shown gains and losses recently and 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, although they have not yet proved their worth. Because of the very wide range of investments they hold, they provide a useful diversification.
Credit (Senior loans, High Yield & Emerging Market Debt)
These floating-rate sub-investment grade securities offer a premium over cash and are useful for diversifying a portfolio.