Could higher inflation and interest rates spell the end of a halcyon period for investors?

Look back on the past year and investors have, on the whole, enjoyed very strong returns. It has been a pleasant ride too over the past 3, 5 and 10 years, punctuated by the odd phase of volatility and one significant market crash in 2020 brought about by the onset of the pandemic. However, those able to turn a blind eye to day-to-day volatility have been rewarded.

Rob Morgan, Chief Analyst, at Charles Stanley Wealth Managers explains...

More recently, we have entered a quieter phase where less seems to be happening. Share markets have been edging upwards and there has been a bit of a swing in focus at times to areas previously left behind such as energy. In bond markets there has been a bit more action than usual as investors grapple with just how much more inflation might be around the corner.

The latest level of consumer price inflation is 5.1% year on year in the UK and is an eye-watering 6.8% in the US, a 39-year high. In ‘normal’ times this sort of inflation would see central banks scrambling to raise interest rates quickly. Yet with the new variant of Covid-19 at large, various factors fuelling inflation attributed to the rapid bounce back from lockdowns, as well as supply constraints for various products and components, authorities have opted for more of a ‘wait and see’ approach. If prices do level off as they suspect then tightening monetary policy too much could be counterproductive as it could kill off a tepid, and possibly Covid constrained, recovery.

Inflation worries

Some investors are worried that high energy costs, shortages of various goods and a tight jobs market could linger for longer than a few months, continuing to push up prices. Among several challenges, the most significant factor holding back the economy is a lack of workers, a problem that is might be resolved with higher wage growth – which is inflationary.

More recently authorities have moved their positions a little, acknowledging the growing threat. The US Federal Reserve has dropped its reference to “transitory” inflationary factors and has slashed its economy-boosting bond purchases faster than previously planned. The trajectory of the Fed’s current thinking now implies three interest rises this year starting as early as spring. A complete contrast to a year ago when it wasn’t expected to raise rates until 2024.

The Bank of England has also begun to harden its stance. December’s small hike from 0.1 to 0.25% will have little practical impact but is symbolically significant that the Bank is taking the threat of stickier inflation seriously. It had reason to delay. The impact of the Omicron variant and accompanying tightening social restrictions is highly uncertain, but it nonetheless chose to act.

A ‘regime change’

Investors therefore find themselves in a changing environment. Last year was about supporting the economy through spending, but if rising prices persist then this year is going to be about cooling things down and trying to make it easier for people to pay for essentials. The good news is that inflation is likely to moderate as we progress further into the year. Year-on-year inflation numbers will become far less alarming as energy prices reach a peak and supply chains unblock themselves. This means there is a good chance that interest rates won’t have to move too far too fast.

It’s still important to be aware that higher inflation and higher interest rates to combat them is a potential headwind to many assets, though. A decent chunk of the Bloomberg Barclays Global Aggregate, the most referenced bond index, provides yields of less than absolute zero and the majority of the benchmark yields below the commonly applied central bank inflation target of 2%. Determination on the part of central banks to raise interest rates could cause a more uncomfortable time for the 40% bond portion of the classic 60:40 equity to bond portfolio that has so often stood the test of time.

There is a potential knock-on impact on equities too. That’s because company earnings, are priced partly with bond yields as a yardstick. The higher inflation, interest rates and bond yields are the less future profits are calculated to be worth in today’s terms. Higher interest rates also increase borrowing costs, which acts as a brake on profitability and a constraint on business growth.

Are investors too nonchalant?

Many investors have limited experience of dealing more inflationary periods and no recent data to guide the repositioning of their portfolios in the face of heighted inflation, if indeed that does transpire. We are therefore cautious that while investment gains can be made this year, they will likely be harder won.

It may be a good time to build some more resilience into portfolios and stay away from areas with a significant degree of exuberance and speculation. There remains plenty of expensive assets with little or no intrinsic value, buoyed by speculation, social media memes and ‘FOMO’ – Fear of missing out. Those taking on too many risks in the same direction could face a tough time, and it may be necessary to think harder about how to construct an investment portfolio.

We believe in being risk aware, selective in terms of asset selection and nimble enough to take advantage of opportunities as they present themselves. Diversification is vital, but it has to be the right kind of diversification. Building a central scenario and accepting that this might be wrong is a good first step. It’s better to be ‘about right’ consistently than alternate between being absolutely right and absolutely wrong. It should mean less portfolio volatility and better enable returns to compound consistently over time. This calls for a portfolio that is made up of assets with varying characteristics and driven by different trends in order to balance risk and reward effectively.

To discuss your investments and the options available to you, arrange your free consultation with a member of our local Investment Management team. Call us on 01865 987485 

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The value of investments can fall as well as rise. Investors may get back less than invested.

Charles Stanley & Co. Limited is authorised and regulated by the Financial Conduct Authority.

This article is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. The value of investments, and the income derived from them, can fall as well as rise. Investors may get back less than invested. Past performance is not a reliable guide to future returns. Charles Stanley & Co. Limited is authorised and regulated by the Financial Conduct Authority.