Quarterly Market Update: The cost of doing nothing

26th July 2022

With markets continuing to experience volatility in the face of rising inflation and interest rates, people have been left with the difficult decision around what to do with their money.

For much of 2020 and 2021, the answer was fairly straightforward. With low inflation and low interest rates, conditions were much more constructive for equities, and especially for ‘growth’ companies. As a result, a number of large technology shares experienced rapid growth over much of the past two years. With equities performing well, passive funds were able to generate strong returns, making it more difficult for active managers to display their value.

Over the past quarter, the situation has changed dramatically. The war in Ukraine, which many commentators expected to be relatively short, has continued on for several months and the fighting shows no signs of stopping. Ukraine and Russia are major producers of important commodities, including wheat, oil and gas. With supplies of these now threatened, prices are beginning to jump rapidly. The cap on fuel prices in the UK in April rose 54%, and many are now predicting it will jump another 40% in October1. Over the past quarter, this has combined with a supply and demand imbalance left over from COVID-19 to create strong inflationary pressures.

The UK ended the Quarter with inflation at a 40-year high of over 9%, and warnings from the Bank of England that it could break 11% this year2. With prices outstripping wage growth, an increasing number of people are struggling financially, with many people facing a cost of living crisis.

The UK is not alone in this, and both the US and Eurozone are facing similar inflationary pressures. With upcoming midterm elections in the US, inflation is expected to be a key issue that could see Joe Biden’s Democrats lose control of the Houses of Congress.

Governments and central banks haven’t sat back idly by but have taken action to try and limit inflation. One of the levers central banks have is to increase interest rates. Higher interest makes it more expensive to borrow, which generally reduces spending, reducing demand, and therefore reducing pricing pressure and inflation. The Bank of England has increased its central rates by 0.25% repeatedly this year, while in the US, the Federal Reserve recently increased its central rate by 0.75%.

Of course, this creates its own challenges. For a population already struggling with the cost of living, additional costs are potentially unwelcome. With many economies still fragile post COVID-19, there is also a risk that if banks were to increase interest rates too much, it could cause a recession.

For wealth managers, this has created a difficult situation. Although we know we are facing high levels of inflation and increasing interest rates, there are still questions we cannot know the answer to. For example, is this inflation transient? How much of the inflation is being caused by the war in Ukraine, and how much is the aftermath of COVID-19? We simply don’t know at this stage. Different asset classes will react differently depending on the answers to these questions.

For example, you may have seen the word ‘stagflation’ mentioned in recent weeks. This is where we have high inflation coupled with a recession, and it’s a real possibility. In this scenario, there are very few places to hide, but typically gold and commodities perform best.

Unfortunately, these two asset classes often struggle in other scenarios – for example, if this inflation turns out to be transient and central banks become too aggressive. This could drive inflation down too far, just as the economy falls into a recession. In this case, you would want to be invested more heavily in bonds.

And what if central banks get it ‘just right’? This is the so-called ‘goldilocks’ scenario, where interest rates help bring down inflation, and we return to growth. In this environment, it is better to invest in equities – and while the idea of share prices bouncing back right now might seem far-fetched, don’t forget how quickly markets turned around in the first few months of COVID-19.

So, there are three different but plausible scenarios, each of which will favour a different asset class. What do you do?

The wrong answer is to take all your money out and hold it in cash until things become clearer. Right now, inflation is over 9%, and is predicted to get higher as the year goes on. Even after the interest rate increases, the central rate is still only 1.25%. A long-term fixed rate Cash ISA isn’t likely to earn much more than 2.5% interest, and you’re going to earn substantially less than this in an instant access account. This means you are guaranteed to lose purchase power with whatever cash you hold.

Instead, the key here is to ensure you hold a well-diversified portfolio, containing well thought-out asset allocations for your risk profile. These are two of our core Investment Beliefs. This way, you will not be too exposed to any one asset class, reducing the risk of volatility, and will be well placed to benefit from any future bounce-back, whatever form it may take.

Past performance is not indicative of future performance. The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select, and the value can therefore go down as well as up. You may get back less than you invested.

An investment in Equities do not provide the security of capital which is characteristic of a deposit with a bank or building society or a Cash ISA.

Sources

1. Ofgem: How Ofgem is responding to the energy crisis

2. Bank of England: Bank Rate increased to 1.25% – June 2022