We are now in a period of higher inflation – so it’s up to the US Federal Reserve Bank and other leading central banks to tighten their monetary policies in a bid to curb this destructive rise. Both equity and bond markets are reacting nervously to a world of rising inflation and higher interest rates, together with a reduction in the Fed’s balance sheet, and this has triggered an initial rotation out of growth and into value stocks.
In the US, the benchmark 10-year Treasury bond price has extended its decline following one of its worst quarterly returns in decades: its yield has backed up to 2.7%, and it is likely to reach between 4.0% and 4.50% over the next 12 months or so. There is little doubt that the three factors that have plagued the markets in the first quarter of this year – inflation, higher interest rates and Russia’s invasion of Ukraine – will continue to affect the financial markets for the foreseeable future.
Some professional investors, however, appear to be taking these challenges in their stride and are relatively unfazed by the possibility that all of this might eventually lead us into a recession. It is worth pointing out that this is not our base case at Investment Quorum. In our opinion, both the US and the UK economy have recovered well from the pandemic and will most likely be in a position to withstand the pressures associated with higher inflation and interest rates.
Household expenses are admittedly rising rapidly. Although some consumers will be hard hit by what lies ahead, many more fortunate ones are sitting on mountains of Covid savings which should see them through these challenging times.
But a more prudent outlook over the short term is sensible: the Russia-Ukraine conflict shows no signs of abating and there will likely be further hold-ups in the global supply chains – which will doubtless have a prolonged effect on inflation.
As energy and commodity prices continue to rise, the West is trying to get the 31 member nations of the International Energy Agency (including the US, most of Europe, Australia, Japan and Mexico) to release a further 120 million barrels of oil from emergency stockpiles. This will be the largest release of oil in the IEA’s 47-year history. Approximately half of that will come from US reserves, included in Washington’s previously announced decision to release 180 million barrels over six months.
However, we must now consider that the squeeze in demand over supply for energy and almost every commodity in the sector is effectively moving the world towards a new commodity super cycle, which looks set to last for some time.
Energy and commodity prices are not alone in having skyrocketed: agricultural prices are also on the move. Global food prices have just risen at their fastest monthly rate in 14 years. The war in Ukraine has hit supplies of grains and vegetable oils. Around a quarter of global wheat exports come from Ukraine and Russia. Similarly, the region accounts for a fifth of the global maize and barley market. And as far as sunflower oil is concerned, Ukraine and Russia are the largest and second largest exporters of it in the world, respectively.
March’s food price index – published by the UN Food and Agriculture Organisation – has risen to its third record high in a row, jumping by 34% from the same time last year. It was 12.6% higher than in February. This will create anxiety for some businesses and consumers, who are already suffering from overall rising household costs.
Purchases of gold exchange-traded products hit a record in March. Global net inflows into gold ETPs rose five-fold month-on-month, eclipsing the previous July 2020 peak. In early March, this surge in buying helped push gold up to within a whisker of its all-time high, doubtless aided by the geopolitical upheaval created by escalating events in Ukraine.
Higher inflation is also causing gold to trend higher. The yellow metal is a proven long-term hedge against inflation (unlike paper money, its supply does not change much year-on-year). Although its performance over the shorter term can be less convincing, gold has nevertheless been an asset class worthy of consideration for the past 2000 years.
Following a healthy recovery in the financial markets that began in mid-March, stock market performances have varied across a number of indices – commentators remain concerned about inflation and continuing tensions in Eastern Europe.
In the US, fears that the Fed is about to adopt an extremely aggressive approach to monetary tightening in a bid to bring inflation down saw longer-term bond yields rally to a three-year high. Meanwhile, a chorus of hawkish voices announcing an impending recession has added further uncertainty to the overall mix.
The Fed’s roadmap for aggressive interest rate hikes and a shrinking of its balance sheet will doubtless affect stock and bond markets. But when it adopted a comparable approach in 2017-2019, equities actually registered a solid game over the first 12 months of the programme.
Indeed, it was not until the second year of balance sheet reduction – close to the end of the rate-hiking cycle – that the 10-year Treasury bond yield dropped from its peak and the S&P 500 Index pulled back by almost 20%, forcing the Fed back into a dovish mindset.
A series of expected rate hikes combined with quantitative tightening over the next two years will mean headwinds for both equity and fixed-income markets. As we get further into the cycle, liquidity is withdrawn and then growth slows, creating challenges for the investment world.
Think back to 2017-2019 – there was much talk of recession, which eventually came to nothing. Similarly, there are no guarantees that we are heading for recession now.
Holding cash remains unattractive over the short term. But this could change as interest rates rise. As far as other asset classes are concerned, sensible exposure to quality growth, value, cyclical and defensive sectors, global income and – to capture the world of tomorrow – innovation would seem reasonable in this current investment cycle.
Although it’s fair to say that bond markets do not look attractive right now, Investment Quorum does not believe that they should be written off entirely – they will have their moment in the sun. For now, however, real assets, infrastructure, real estate and private equity are all viable alternatives to equities and cash deposits.
