The financial markets remain nervous as fears rise over tighter monetary policy, while the prospect of a Russian invasion of Ukraine weighs heavily on investor sentiment. As far as market outliers are concerned, inflation continues to rise, prompting hawkish commentary from senior voting members of the Federal Reserve Bank, the Bank of England and the European Central Bank.
On Wall Street, the market is now pricing in an 86% probability that the Fed will raise short-term rates in March, while in the UK, inflation is expected to hit around 8% by April, adding further pressure to already hard-pressed households.
Although UK Chancellor Rishi Sunak has indicated that the government understands the challenges that people are up against as the cost of living rises sharply, a leading UK thinktank has warned that inflation could cost the Treasury an extra £11 billion this year, serving the national debt of more than £2 trillion. He went on to defend the government’s current position, promising to provide millions of households with up to £350 to help offset rising energy bills.
In Europe, concerns over an imminent invasion of Ukraine by Russia show no signs of waning. President Biden has made it clear that the US would defend NATO territories should the need arise, and that the sanctions that the world would impose on Moscow would be severe. Such a move would undermine Russia’s ability to compete economically and strategically: Moscow will need to think very carefully about its next move.
Being able to cut gas flows to Europe is Moscow’s trump economic card. With that in mind, the US (a net energy exporter) and the European Union are discussing the possibility of securing alternative energy supplies.
Meanwhile, the European Central Bank has indicated that it will consider raising interest rates in the second half of the year – rather than waiting until 2023 (as previously expected).
This change of plan has come about as concerns mount over the aggressive rise in consumer price inflation rates across Europe and fears that if it does not take action quickly, it may expose itself to accusations of perceived policy errors – the same as the fate that befell the Federal Reserve Bank. In the UK, meanwhile, the Bank of England has already raised interest rates twice, and further rate hikes are now an inevitability.
The current economic backdrop shows some very mixed messages: in the UK, GDP has risen more than expected, rebounding nicely from its pandemic slump. In Europe, however, forecasters are predicting a slower rate of growth for 2022.
In China, with economists having declared that the worst of the country’s regulatory crackdown was over, the Shanghai Composite Index surged by over 3%. But with the country’s service sector having grown at its slowest pace in five months, China’s policymakers recently cut interest rates in a bid to stimulate economic growth. Further monetary stimulus is likely from Beijing – the polar opposite of what central banks in the West are doing with their significantly more hawkish stance.
Regarding the financial markets, two important concerns appear to have been addressed. Firstly, the central banks have finally recognised that we do indeed have an inflationary problem: commentators are no longer talking about transitory inflation. The word “embedded” is now featuring prominently in their discourse. Secondly, they are open to moving faster on their monetary tightening policies than previously indicated. This was met by a nervous reaction in the bond markets, followed by an additional rotational move within certain global sectors.
However, what we still do not know is whether inflation will remain relatively high, or whether higher interest rates in the UK and the US will bring that rate down to something approaching the Federal Reserve Bank’s and the Bank of England’s 2% target rate. What we want to avoid is a period of stagflation – a period characterised by slow economic growth, rising prices and relatively high unemployment.
At the same time, the central banks are going to remove their monthly bond buying programmes. These have acted as an insurance policy (or stimulus) for risk assets over the past decade. A new stimulus will therefore need to be found for the markets. Needless to say, that is a role that can be played by stronger corporate earnings.
Therefore, from an asset allocation perspective, owning quality companies with resilient balance sheets and pricing power remains a sensible strategy in a higher inflationary environment. It should always be remembered that innovation is the most important driver of stock returns. Furthermore, any company that has a secure and rising dividend will allow you as an investor to compound your investment returns.
We therefore believe that owning a mix of quality growth businesses, global dividend providers and companies that innovate and disrupt, will provide a global investor with attractive opportunities for capturing some exciting long-term returns.
That said, in recent weeks the markets have been somewhat unkind to a number of businesses that meet the above description. This was not all that unexpected, given that several of them appeared to have rather stretched valuations.
In times such as these, draw on your inner Warren Buffett and simply accept that there are going to be bumps, hiccups and corrections from time to time. Your inner Warren Buffett will tell you that these are simply good buying opportunities and not necessarily cause for alarm.
