What does high inflation mean for your investments?

How did we get here?

The current 'crisis’ has undoubtedly been fuelled by inflation. While we're led to believe this has solely been triggered by the war in Ukraine, many of the contributing factors have been bubbling for some time, from post-pandemic supply issues to excess money in the system from vast amounts of quantitative easing. The war in Ukraine and subsequent sanctions placed on Russia has hastened the increases in inflation through the reduction in agricultural output and skyrocketing energy prices, creating ‘stickier’ inflation than was once anticipated.

It hasn’t just been a problem for the UK, but worldwide, US inflation remains high (8.2% in September) and similarly, the Eurozone (9.9% in September). Inevitably, this has led to interest rate increases introduced to curb demand, which has had little effect so far, with rates going up further and faster than first anticipated. The US Federal Reserve have been more aggressive with their rates, increasing them to the range of 3.75%-4%, while the UK rate is currently 3% and the Eurozone 1.25%- 2%. The Bank of England is expected to continue to raise rates in the coming months. Despite the aggressive rate rises, it’s been widely acknowledged that all central banks have acted ‘behind the curve’.

The US Federal Reserve’s more aggressive actions have compounded the inflationary pressures in the UK and Eurozone, with both Sterling and the Euro depreciating heavily against the US dollar, increasing the cost of many imported items and that of commodities, critically oil, which is priced in dollars.

What effect has this had?

Equity markets have been volatile throughout 2022, inflation, interest rate increases and the war in Ukraine affecting all global stock markets negatively. 

Perhaps surprisingly, the UK stock market has held up better than others, despite the widespread dire warnings on the UK economy and government disarray, in stark contrast to the portrayed strength of other major economies, particularly the US. Country-specific news isn’t always reflective of stock market returns, the UK stock market excelling relatively, largely due to the constituents of the index (heavily oil and gas) and also currency returns (earnings in dollars converted to sterling). The US stock market has perhaps struggled more due to the heavy presence of technology-led stocks, projecting earnings and growth into the future, discounted now at much higher interest rates than before, therefore reducing valuations.

Ordinarily, in times of turmoil, you might expect lower-risk government and Corporate Bonds to prop up a portfolio and provide the ballast. However, we find ourselves in both a time of economic uncertainty and rapidly rising interest rates causing bond yields to climb quickly and prices to fall. These falls in bond values have been exacerbated in recent weeks in the UK by government policy, unfunded tax cuts (now mainly reversed), a fiscal deficit and record debt levels have highlighted the fragility of the UK’s credit rating. A ‘run’ on defined benefit pension liability-driven investment schemes pushed UK Government Bond yields to levels not seen since the global financial crisis and forced the Bank of England to step in, buying bonds to shore up the system at a time when they should have been unwinding bond positions bought during the quantitative easing period of the pandemic.

There have been little in the way of hiding places, of the traditional asset classes (equity, fixed interest, property and cash), only property has acted as a real diversifier in this period. It’s been a scenario where almost all investors have been affected, both lower-risk or high-risk have all found themselves in negative territory to similar proportions this year.

Where are we heading?

Due to the relative short-term nature of some of the causes, and the view that market forces will gradually adjust economies back to more comfortable territory, most believe that the high levels of inflation that are currently being experienced globally, will start to ease. The Bank of England currently expects UK inflation to peak later this year and then progressively return towards its 2% target over the next couple of years.

However, despite politicians and central banks’ efforts to reassure people that they have the tools to control inflation, in most western economies, policymakers are currently caught between a rock and hard place, reducing inflation and avoiding a recession.

The instinctive tool to tackle rising prices is to tighten monetary policy. We’ve seen this already with interest rate increases and, most central banks are expected to continue to rise rates throughout this year and early into 2023, in the UK predicted to peak at between 4 and 4.5%. There are challenges that come with tightening of monetary policy. It’s difficult to be a reactive short-term fix as monetary policy changes generally take 12 months to see results.

It’s for this reason we are likely to see rates remain higher for longer, perhaps throughout 2023 before we see central bank policy shifting in attempt to re-stimulate growth. We’ve seen this already in the UK with a growth agenda firmly taking a back seat in favour of reducing inflation and debt levels. There may be more short-term pain before we see the recovery.

As an investor, what can you do?

While we’ve painted a rather grim picture of 2022 and the pain may continue for a little while longer yet, investors shouldn't let the current crisis affect their long-term strategy. 

As an investor, you should try to remain invested and stay the course, reacting by leaving the market is just another form of market timing. Ultimately, markets are largely efficient and incorporate all available information, thus, once information related to the event is known by investors, prices have already adjusted. If you exit the market, you must also re-enter in order to obtain real returns and, this often comes after the rebound has begun.

While major events and their unknown impact on asset prices create uncertainty for investors, the uncertainty is a major reason why investors earn a greater return. Investors are better prepared to apply discipline during a crisis if they have realistic expectations, take a long-term view of markets, and understand why some investments have higher expected returns.

While it’s difficult to predict how events will impact markets in the short-term, what we observe from history is that markets recover. In the past 50 years, there have only been three occasions (1987, 1990, 1994) when both global bond and equity markets have finished the year in negative territory, 2022 may well be the fourth. However, on each of these occasions, markets have rewarded disciplined investors as a strong recovery has followed.

Final thoughts 

Having an investment strategy that is linked to objectives and accounts for periods of market decline can help you focus on the long term. A well-constructed financial plan is essential to successful investing.

As we are witnessing, there will be periods when asset prices fall and events affect assets differently. Diversification across global assets linked to your financial plan can help investors endure a market downturn.

An emergency fund can also prove crucial in times like this, allowing you time for assets to recover should there be a short-term requirement for cash.

This insight has been prepared to keep readers abreast of current developments. Professional advice should be taken in light of your personal circumstances before any action is taken or refrained from. To speak to one of our investment specialists, please contact Matt Hodge or Seth Dowley in our Financial Planning team. Alternatively, fill out the form below and we'll be in touch shortly.