Central banks war-game their inflation scenarios in public
Stock markets moved higher through October but whipsawed downwards towards the end of November as the emergence of the Omicron variant hit markets that were partially closed for US Thanksgiving. Over the two-month period, US equities rose by around 8% in sterling terms, boosted by the strong dollar. Other markets were broadly flat except for Japan, which fell over 4%. Bond traders suffered a torrid couple of months as central banks in the US and UK war-gamed their inflation scenarios in public, with year-on-year consumer price inflation exceeding 4% in the UK and Eurozone and remaining above 6% in the United States.
A two-month tale of momentum and reversal
Over the two-month period, and in sterling terms, stock markets in the United States rose by around 8%, boosted by the strong dollar. Other markets were broadly flat except for Japan, which fell over 4%. Fixed interest bonds were mixed, with corporate and high-yield bonds reflecting the nervousness in equity markets, while UK gilts rose by over 4% with the index-linked sector gaining 10%.
The interpretation of economic data did not get any easier. Output and growth reports were mixed around the world, with China noticeably slowing but growth elsewhere expanding, albeit at a slower pace. Data on jobs and inflation were, however, more emphatic. Employment data in the US, EU and UK showed greater numbers returning to work, despite the ending of furlough schemes, and record numbers of vacancies for new jobs. Inflation continued to hit multi-year highs, with year-on-year consumer price inflation exceeding 4% in the UK and Eurozone and remaining over 6% in the United States.
The Bank of England surprises, the Fed retires "transitory"
Bond traders suffered a torrid couple of months as central banks in the US and UK war-gamed their inflation scenarios in public. The Bank of England was first to warn that it was concerned with above-target inflation and that the UK should brace itself for "significantly earlier" rises in interest rates. This was taken as a nod towards a rise at the November meeting, sending bond yields higher. In the event, members voted 7 to 2 to maintain rates at current levels, leading to a vicious reversal in bond yields and a fair amount of criticism directed at Governor Bailey for misleading the market.
In the United States, President Biden re-nominated Federal Reserve Chair Jerome Powell for a second term, with member Lael Brainard as his deputy. Over the course of two months, the Fed moved from signalling that a start to tapering bond purchases was imminent, to admitting that it had underestimated the strength of inflation to the point that the word "transitory" could be retired. Chair Powell's latest speech suggested that the tapering programme could be increased in size and wound up a few months sooner than previously expected.
The epitome of consistency, the European Central Bank recalibrated their bond purchases a touch lower but did not even contemplate future rises in rates, despite the highest inflation since the single currency began.
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
An unusually broad spread of possible paths
Up until Thanksgiving, the narrative had simplified: there was general agreement that although inflation might yet prove to be temporary, it currently warranted attention from central bankers. The questions were more about how soon to start raising interest rates and where the rate cycle was likely to peak. Then, at the flick of an Omicron switch, the bond market surged to price in a postponement of likely rises, deeming them too risky if the world entered various degrees of lockdown.
We cannot predict how central bankers or politicians will react to this latest outbreak, but there are a few points we find relevant to the interest rate debate. Interest rates were cut to record lows in early 2020 as an emergency act in response to the uncertainty created by the onset of the pandemic. It is reasonable to suggest that the same level of panic no longer exists and therefore some, or all, of the emergency cuts should be reversed. Relying on economic data will remain tricky for some time due to the comparison to base effects of activity during the pandemic. We also cannot yet tell whether a slowdown in growth is due to slowing demand or simply because supply constraints mean that orders cannot be met. Raising rates cannot build cargo ships or produce semiconductors, but it can signal to investors and workers that central banks are alert to inflationary pressures.
Any assessment of Omicron and its consequences is highly conjectural at this stage. Its discovery simply adds to the unusually broad spread of possible paths for economic activity, inflation and interest rates. As things stand, there has been a change of emphasis in Fed thinking, with members showing more anxiety over rising prices than missing employment targets.
Over the longer term, interest rates are unlikely to offer a return above inflation. A diversified portfolio offers the best prospect of producing long-term gains.
Several gauges of inflation expectations suggest a belief in the transitory theory, but over a longer time period. In the bond market, flattening yield curves and forward inflation breakeven levels suggest that investors do not think inflation will endure much past five years. Less mathematical surveys of consumers support this belief. Over the longer term, we believe that interest rates are unlikely to offer a return above inflation. Equities will remain volatile, but a diversified portfolio offers the best prospect of producing long-term gains.
Portfolios have been repositioned to increase UK value exposure and broaden diversification into Japan and emerging markets, while ESG considerations continue to shape fund selection.
Increased UK value exposure
An autumnal pullback provided the opportunity to increase exposure to value in the UK, where our preferred vehicles are Artemis UK Select and MAN GLG UK Income for income portfolios, along with the existing bias to small and mid-cap stocks.
Broader international diversification
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. Overall risk has increased slightly, in line with the increased exposure to equities.
ESG integration in fund selection
Existing holdings in Troy Trojan and Unicorn UK Income (the latter on our income portfolios) have been switched into their ethical versions. ESG is an important theme, and we will continue to seek out individual funds in this area that fit with our overall strategy.
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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