Overview
Extreme heatwaves during the summer were contrasted by chill winds blowing across the global economy. On home soil, UK inflation rocketed to a 40-year high of 10.1% in July. With energy costs being a key driver of this figure – as with most countries – the government’s energy price guarantee and support for businesses were widely welcomed. They are measures that will certainly help to rein in national inflation.
However, many central banks around the world had no option but to continue raising interest rates during Q3, as another way of applying the brakes on what appears to be runaway inflation. The Bank of England’s Monetary Policy Committee (MPC) – which decides the ‘base rate’ of interest for the UK – postponed its September meeting by a week, as a mark of respect following the death of Her Majesty Queen Elizabeth II. When the MPC eventually announced a 0.5% increase on 22 September, there was some surprise among markets that had been considering a 0.75% rise.
Despite this, a UK base rate of 2.25%, at the time of writing, is still the highest it has been since the global financial crisis in 2008, which speaks volumes. Inflation here is five times the Bank of England’s target level and, perhaps unsurprisingly, further interest rate rises are expected to help combat this. Financial markets are now suggesting that they could reach as high as 6%. In our team’s view, this is not yet justified and feels too aggressive given the impact it would have on people’s mortgages and other debt repayments.
Inflation nations
Until inflation noticeably slows down, there is a real risk that interest rates will need to keep rising, and that soaring prices for goods and services could become the norm. As seen in recent months, this has the power to severely impact everyday consumers and how far their pay packets can stretch. Central banks and policymakers have a very tricky tightrope to walk when attempting to reach a solution: raise interest rates too high, too quickly, and an economy can go into reverse gear, but raise them too slowly and inflation will continue to race onwards and deepen the cost-of-living crisis.
The UK’s approach to date – which has been matched more closely by cautious economies such as the Eurozone – is in stark contrast to the US Federal Reserve, which has raised rates swiftly and sharply. This has further fuelled the strength of the US dollar, meaning that currencies such as sterling and the euro have fallen against it. International markets also viewed the UK government’s mini ‘tax-cutting’ budget on 23 September with a sceptical eye, which soon after led to sterling falling to its lowest level against the dollar and caused government bond prices to fall even further. This prompted intervention from the Bank of England as it stepped in to buy long-dated UK government bonds in a bid to bolster market confidence. It may also have prevented, in the short term, a crisis for millions of people’s pension funds which historically have large holdings of gilts – leaving the Bank of England supporting the gilt market to the tune of billions.
From a UK-based investor’s perspective, this backdrop is important because it makes investing in US companies (equities) much more expensive. It also means that commodities – such as oil and gas – that are priced in dollars will effectively cost more too. That said, it is good news for companies listed on the FTSE 100: approximately 80% of their earnings come from overseas and the majority is in dollars, meaning they benefit financially when those earnings are converted back to sterling.
Businesses, bonds and bottlenecks
It would be easy for people to assume, given everything discussed so far, that US businesses and equity markets have shown as much boldness as the Federal Reserve and dollar performance. Put simply, they haven’t. Essentially, the dollar’s strength has masked the underlying weakness of US equities. In fact, most developed market equities declined during August and September, largely due to similar fears of further interest rate hikes. International bond prices also fell during the period, which added to widespread disappointment for investors. In a nutshell, this is because higher interest rates hurt global equities as well as international bonds.
Supply-chain bottlenecks, meanwhile, which have previously been a major issue for manufacturers, began to unblock. However, everyday consumers are under a lot of financial pressure, meaning they are more likely to cut back their spending on goods. We are already seeing this translate into disappointing performance among some companies, particularly those saddled with inventory stockpiles. The silver lining is that such a scenario should help bring down the price of goods, and therefore inflation, as retailers will need to cut their prices to match consumers who are buying less. That said, this will undoubtedly weigh on affected companies’ earnings and profit margins. This is just one of many issues that our team continues to take into account when looking at potential investments.
Another knock-on impact of all the above is that it will add to equity market volatility for the short-term future, especially when other elements such as Russia’s unpredictable actions are taken into account. Indeed, towards the end of September, Vladimir Putin announced a new conscription, to swell Russian troop numbers by about 300,000, while ramping up his personal rhetoric regarding his country’s nuclear capabilities.
Our Fund Managers and outlook
Exactly how volatile markets will be in the coming months depends on geopolitical issues as well as how policymakers, businesses and consumers behave. Recessions appear to be increasingly likely in the US, Eurozone and the UK. In Q3, the Bank of England even expressed its belief that the UK may have entered a technical recession. But such economic cycles, in themselves, do not deter long-term investors like us.
Our Fund Managers firmly believe that carefully selected equities will be in the best possible position to handle either stagflation (a period of slow growth, rising unemployment, and mounting prices) or recessions. This is because the valuations of major global stock markets have already factored in associated issues, including the likelihood of lower business earnings. That is also why our in-house Analysts typically spend so much of their time focused on researching sectors, companies and trends in geographical regions, to help our Fund Managers identify suitable equity investments.
Our team are also continuing with a gradual push into emerging markets and, more recently, bonds. Higher interest rates have presented us with more attractive opportunities in both government and corporate bonds. When it comes to emerging markets, China dominates, so it is a natural region of interest for us; however, it comes with additional environmental, social and governance risks to pay attention to.
Finally, during the global market weakness seen this year, it is worth sharing a reminder that our Fund Managers, as ‘contrarian’ investors, take short-term market noise and geopolitical events into account precisely so they can invest in assets they believe will perform well for our funds – and our customers invested in them – over the longer term. This approach has been carefully designed to achieve sustainable and competitive returns for our customers over time, in line with their future financial goals.