Peak uncertainty for markets
The past month has been a challenging one for all investors. It has been characterized by growing pessimism about the global economy, rising fears about inflation and its impact on everyday life.
Ironically companies posted better than expected earnings in the first three months of the year. However, this did not mask the fact that forward-looking indicators of economic activity have slowed materially. Consumer confidence around the world is in precipitous decline and all this occurred before central banks began to push through the sharpest increases in borrowing costs in a generation.
Taking one’s medicine:
The US Federal Reserve, as expected, raised interest rates by 0.5% on the 5th of May 2022. It will start reducing its enormous balance sheet, which has been swollen by ten years of quantitative easing, in June and is expected to raise rates by a further 1% by the end of July.
The Bank of England, in contrast, took a more cautious approach and raised interest rates by a quarter of a percentage point. Sterling fell sharply versus the dollar, as currency investors reacted to the bank’s dithering response.
An old foe:
Financial markets have endured several periods of high inflation during the past century.
The roaring 1920’s, a period of hyper credit growth, gave way to bank failures and the great depression. The lessons learnt led to deposit insurance and enhanced banking regulation. World War Two saw a spike in inflation as the world mobilized to fight and then rebuild. The stock market struggled to make headway post-war but resumed its upward trend during the 1950s as inflation fell. The Arab oil embargo in 1973 led to a quadrupling of oil prices which impacted consumers across the developed world. The subsequent recession failed to stem inflation. Bonds and equities delivered poor real returns over the following decade.
In 1980, Paul Volcker raised interest rates to 20% to break the inflationary spiral. The 1980s recession was deep but helped cement central bank credibility and deliver robust bond and equity returns in the decades that followed.
The lessons learnt during the 1970s have helped shape monetary policy ever since. Whilst policy has wavered in recent decades, this has happened in the absence of a meaningful inflation threat.
The Federal Reserve, after some dithering of its own, has started to act aggressively to avoid a repeat of the 70s. For now, investors believe in the Fed’s resolve and are willing to stick to traditional asset allocations, despite rising near-term volatility.
Upsetting the apple cart:
While there was a reasonable basis to argue that the post-pandemic spike in inflation would prove transitory, the spike in energy prices eliminated such wishful posturing. The inflationary impact of supply chain disruptions pales in comparison to the pervasive inflationary pressure higher oil represents.
Russia supplies 10% of the world’s oil and a decline in its output through war or sanctions will push up energy prices and act as a tax on global consumers. Central banks cannot impact the supply of oil and are therefore helpless in the wake of this threat. What they are trying to avoid however is a rerun of wage inflation that plagued the 70s. This can only be achieved through a drop in employment or a short sharp recession.
Prepared for uncertainty:
We have been on a more cautious footing with regards to our asset allocation since November 2021. This shift in tack was driven by a change in tone at the Federal Reserve. In January we increased our allocation to dollar assets, global infrastructure and sold emerging market equities. All three decisions have added value in 2022.
Our bond allocations have declined in price as central banks push through rate increases. 50% of our allocation to global bonds and corporate debt have shorter durations. These allocations have fallen significantly less than the broader bond market.
We understand that worsening economic growth and rising yields represent a clear and present danger to portfolio returns. We are closely monitoring our exposure to smaller companies as these positions tend to fall the most during an equity selloff. A slowdown in economic growth will, at some stage, cause a fall in inflation. This decline should allow longer-dated bonds to rally significantly as investors start pricing in the end of policy tightening. We will seek to extend the duration of our bond exposures at a suitable time to take advantage of this opportunity.
We have always maintained that financial conditions determine forward-looking portfolio returns. As financial conditions tighten, investors must prepare themselves for a period of lower returns and adjust portfolios to dampen the impact of higher volatility. It is important to act in a timely manner to reduce risk. While we have taken significant steps to reduce risk this year, we stand ready with a clear plan for additional action.
Whilst the economic environment can seem daunting and lead many to feel nervous about their investment returns it is vital to remember that big changes bring opportunities as well as threats. In recent weeks we have seen the yield on offer from investing in the bonds of good companies rise significantly. Such changes, whilst unsettling in the short term, will ultimately create compelling opportunities for us to harness.
It is also vital to remember that the financial plan developed by your financial adviser always foresaw years in which the market would fall. These events are not so out of the ordinary as to threaten the plans of those investors who are committed to long-term investment and are able to stay the course and harness the opportunities that appear.
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