Inflation takes centre stage as central banks shift their stance
Despite a challenging start to December, with the Omicron variant spreading rapidly, equity markets enjoyed strong gains. The UK and Europe rose by over 4%, and although the US lagged with a 2% gain, it hit record highs towards the year-end. Meanwhile, employment and inflation data remained unquestionably strong, with headline inflation hitting 5% in the UK and Europe and 6.8% in the US, prompting the Bank of England to raise interest rates and the Federal Reserve to accelerate the tapering of its bond purchases.
Strong equity gains despite the Omicron wave
Stock markets in the United Kingdom and Europe rose by over 4% during December, and although the US lagged with a 2% gain, it hit record highs towards the year-end. Asian markets enjoyed gains of around 2.5%, but Japanese and emerging markets were flat. Government bonds continued their rollercoaster ride, losing around 2.5%, with the index-linked variety falling 5%.
Data showed a continuation in global economic growth, albeit at a more subdued pace than earlier in the year. Globally, manufacturing reported an acceleration in output, new orders and employment, while business optimism indicated that companies expected output to rise further over the coming year. However, within the survey, some countries were affected more than others by Covid-related lockdowns, supply problems and rising energy prices. The service sector reflected contrasting fortunes: the United States saw activity at record highs, while the UK and parts of Europe experienced mild slowdowns, hit by the early and rapid spread of Omicron.
Unemployment falls as inflation hits multi-year highs
The economic data most in focus, employment and inflation, remained unquestionably strong. The rates of unemployment in the US and UK both dropped to 4.2%. Inflation remained the hottest topic, with headline rates hitting 5% in the UK and Europe and 6.8% in the US. Although many countries showed price rises in the 2% to 4% bracket, Turkey took the honours with a rate of 36%, of which 14% reflected rises in December alone.
The Bank of England moves first
Having surprised markets a month earlier, the Bank of England was first to react by raising interest rates to 0.25%. The US Federal Reserve then dialled up the rhetoric in announcing that it would speed up the tapering of bond purchases, with the implication that this could bring forward the first rise in interest rates to March 2022. Minutes from the latest meeting reported some members wanting to bring forward quantitative tightening, a step considerably further than simply reducing the pace of bond purchases.
A note from the desk
I am pleased to share our monthly update on market events. The overview seeks to summarise market movements together with our views and the rationale for the positioning of investments going forward. As always, should any aspect of this commentary prompt a question, we would welcome the conversation.
Martyn Charlwood · Managing Director
Navigating between the pandemic and persistent inflation
Moving into 2022, the focus is on whether central bank monetary policy can steer the economy between the future unknowns of the Covid pandemic and the transitory or persistent nature of inflation. While the number of Covid-related deaths continues to drop, the disruptions to economic activity from absent employees and possible further government restrictions remain a concern for investors. Data in the coming months will shed more light on how badly Omicron affected the workforce and consumer spending in December, but for now, New Year optimism favours the view that variants will become more flu-like and less of a strain on the economy.
The debate over whether inflation is just a longer form of transitory or becoming more deeply embedded will rage on for at least the first half of the year. We do not know the answer, but we remain of the view that markets still have not priced in much of a risk. The market expectation is for interest rate rises in the US and UK during the first quarter, and for a further three in the US this year, yet the UK 10-year gilt still only yields a touch over 1%. Fed Chair Jerome Powell recently stated that inflation would stay high until mid-2022, a full year later than his original forecast.
Cash and bond yields are a long way below inflation. A diversified portfolio, favouring equities over bonds, remains the best way of producing inflation-beating returns over the long term.
There remains a significant risk of policy error by the central banks in either direction. For now, the risk is that they are already late to the game in tackling inflation. The consequent risk could be one of over-tightening policy just as some of the inflationary pressures work their way through the system. Interest rates are starting to rise, but cash and bond yields are a long way below inflation. Those with cash savings will see the real value of their money diminish unless they can find investments offering higher returns.
An autumnal pullback provided the opportunity to increase exposure to value in the UK, while positions in Japan and emerging markets have also been added. Portfolios remain diversified across a wide range of assets, with limited bond exposure and a deliberate bias towards inflation protection.
Increasing value exposure in the UK
An autumnal pullback provided the opportunity to increase exposure to value in the UK. Elsewhere, exposure to Japan and emerging markets has been increased. These are also value-orientated markets that have lagged recent trends favouring the US and its more glamorous growth stocks.
Slightly higher overall risk
Overall risk has increased slightly, in line with the increased exposure to equities. We remain of the view that equities offer the best prospect of producing inflation-beating returns over the long term.
Underweight fixed interest
We remain underweight fixed interest. In the portfolios that require bond exposure, we favour those funds linked to inflation or rising interest rates and with limited exposure to rising yields.
Diversification through alternative assets
Our portfolios diversify risk by investing in a wide range of assets using actively managed funds with sound investment processes. Some examples of these alternative assets are funds invested in gold & silver, infrastructure, agriculture and absolute return strategies.
Important information
This article is a marketing communication intended for general information only. It does not constitute personal advice, a recommendation, or an offer to buy or sell any investment. If you are unsure whether an investment is suitable for your circumstances, please seek personal advice.
Past performance is not a guide to future performance. The value of investments and any income from them can fall as well as rise. Capital values are at risk and not guaranteed. Forecasts and views expressed in this commentary represent our assessment at the time of writing and are subject to change.
To discuss how this commentary applies to your own portfolio, we would welcome a conversation.
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