Markets confront the spectre of stagflation
Global investment markets took a turn for the worse with the tragic events in Ukraine. While insignificant in comparison to the suffering of Ukrainians, the task of investors was to focus on the implications for economic growth and inflation. Commodity prices ratcheted higher, sending share prices lower. The immediate effect on fixed interest bonds was to see safe-haven buying driving yields lower, but subsequent fears of higher inflation for a prolonged period led to a reversal of fortunes.
Equities slip as commodities surge on sanctions
At the end of February, stock markets were between 1% and 2% lower, but the escalation of events saw shares fall by a further 2-3% in early March. The exceptions were those companies that benefited from the production and supply of commodities. The UK government bond index registered a fall of over 7% since the start of the year. Emerging markets in both bonds and equities suffered further.
Economic data, which reflected a world before the invasion, confirmed continued growth, with unemployment falling and some easing of supply bottlenecks. Inflation remained a problem, with further price rises exceeding expectations: headline inflation in the United States hit 7.9%, while the United Kingdom and European Union reported 5.5% and 5.8% respectively. A range of sanctions against Russia increased concerns that rising fuel and commodity prices would drive inflation even higher, and quite possibly for longer than previously anticipated.
Rhetoric hardens as the ECB surprises with a hawkish tone
February featured rhetoric rather than actions from central bankers, and this had been expected. Members of the US Federal Reserve indicated a general, though not unanimous, preference for a 0.25% rate increase at their next meeting, but remained open to a 0.5% rise at some point during the year.
At the March meeting, European Central Bank members recognised the stagflationary headwinds by revising their growth forecast for the year down from 4.2% to 3.7% but boosting their inflation expectations from 3.1% to 5.2%. Investors were surprised by the hawkish tone, which suggested members were prepared to raise rates earlier than previously expected.
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
The task of central banks has been made considerably trickier
Events in Ukraine have thrown the world into turmoil and we have had to re-assess previous assumptions. Inflation will remain an issue, driven in the near term by the parabolic rise in fuel and some commodity prices. If the conflict prevents the planting of wheat crops in Ukraine, that could have significant ramifications for global food supply and further price rises.
Current levels of inflation cannot be ignored, but it is not clear that raising rates will provide the solution to a voluntary shortage of commodities brought about by sanctions. We think some rate rises are inevitable, but that central bankers will be watching second-round effects such as wage rises, and whether companies can pass on higher costs to consumers, in considering the extent of future increases. If higher prices lead to a wage-cost and price spiral, we would expect higher interest rates to be needed to push growth below trend. If demand subsides, leading to slowing growth and rising unemployment, we would anticipate a more cautious approach to interest rate policy.
Market traders are increasingly pricing in a fear of stagflation, an unhealthy combination of rising prices and slowing growth. This has been very noticeable in the fixed interest yield curve, where short yields have been rising more rapidly than those on longer-dated bonds, reflecting an expectation that slowing growth will force rates to fall again within a few years.
History shows that remaining calm and invested during such periods produces the best long-term returns.
These are clearly worrying times, and stock markets are in a period of higher volatility. But in these times we need to separate the emotions of human tragedy from cold analysis of the investment process. Cash and bond returns will remain below inflation for some time, diminishing the real value of savings. We remain of the view that a diversified portfolio, favouring equities over bonds, remains the best way of producing inflation-beating returns over the long term.
We have identified levels that we think present good entry points for long-term value and will be monitoring these over the coming weeks with a view to investing if opportunities arise.
Underweight fixed interest
We are likely to remain underweight fixed interest for the foreseeable future, as yields still offer little reward for the potential risk of capital loss. In portfolios that require bond exposure, we favour funds linked to inflation or rising interest rates, with limited exposure to rising yields.
Equities over bonds
Cash and bond returns will remain below inflation for some time, diminishing the real value of savings. A diversified portfolio, favouring equities over bonds, remains in our view the best way of producing inflation-beating returns over the long term.
Alternative assets for diversification
Our portfolios diversify risk by investing in a wide range of assets using actively managed funds with sound investment processes. Examples of these alternative assets include funds invested in gold and 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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