As global equity and bond markets sold off around the world on Friday – and indeed over most of the week – the Federal Reserve Bank and other central banks continued with their drive to tackle inflation by hiking up interest rates.
US investor and financial commentator Jim Rogers points out that ten- to fifteen-year lows are not common, but acknowledges that they do happen. “During these times”, he says “don’t be shy about going against the trend and investing; you could make a fortune by making a bold move. Or you could perhaps lose your shirt. Always remember to invest in an industry you’ve researched thoroughly. Then prepare to see your investment sink lower before it turns around and starts to pay off”. His words echo those of Founding Father Benjamin Franklin, who opined that “an investment in knowledge pays the best interest”.
Recent events have all confirmed that the financial markets have been adjusting to the new reality of a prolonged (not transitory) period of inflation, combined with much higher interest rates and the prospect of a global recession.
The bad news is that we are now seeing the indiscriminate selling of virtually every asset class known to man. But the good news is that capitulation tends to characterise the end of every bear market there has ever been. And capitulation is what is happening right now. Indeed, it could quite possibly extend into October.
Speaking of October, it’s a peculiar month with its own special place in financial history. There is even something referred to as the “October effect”: the Bank Panic of 1907, the Stock Market Crash of 1929 and Black Monday of 1987… they were all October events.
Traditionally, investment sentiment can fade as we slide into autumn and winter. But this year, inflation, rate hikes and the spectre of recession are combining to weigh extremely heavily on investor sentiment.
History has shown that traders and investors can exercise a powerful psychological effect on the markets in October. But this can make it one of the better months for buying opportunities – particularly if you are a contrarian investor with a longer-term view.
In actual fact, it’s September – not October – that is the worst month for investment returns. The foundations of the 1907 and 1929 crashes, for example, were laid in September (or just before), with the reaction being delayed until Armageddon ensued the following month.
The best month for returns tends to be December, closely followed by November and April. So do not be a slave to capitulation.
The somewhat aggressive tone that Federal Reserve Bank Chair Jerome Powell has adopted in his determination to crush inflation at all costs has spooked the markets. His decision to raise interest rates by a further 0.75 basis points (for the third consecutive time) has created a wave of negativity from New York to Vatican City. And he has hinted that there is more to come.
In the UK, meanwhile, the Governor of the Bank of England raised rates by only 0.50 basis points. In view of what happened next, this turned out to be a surprisingly measured move. In his first “new era” mini-budget, recently appointed UK Chancellor Kwasi Kwarteng unveiled the biggest raft of tax cuts this country has seen for 50 years. Numerous MPs and political commentators across the spectrum accused him of recklessness, pointing out that such cuts only benefit the rich. Kwarteng’s £45 billion package of tax cuts sent sterling crashing to its lowest level against the US dollar in 37 years. Since Friday, the pound has continued to weaken, even nearing parity with the dollar at one point in the early hours of Monday.
In a high-risk strategy designed to revive the UK’s sluggish economy, the Chancellor has announced more than £400 billion of extra borrowing over the coming years. This is designed to finance the biggest giveaway since Tony Barber's ill-fated dash-for-growth budget of 1972. The Bank of England, meanwhile, will need to continue to raise the cost of borrowing.
The Treasury admitted that no data had been produced forecasting the impact that these measures might have on growth. This admission was met with incredulity and hostility by Labour and the markets. Former US secretary of the treasury Larry Summers even told Bloomberg that “I think the UK is behaving a bit like an emerging market turning itself into a submerging market”.
He went on to suggest that the UK would be remembered for “having pursued the worst macroeconomic policies of any major country in a long time”. At best, our new Chancellor has delivered a very brave first mini-budget. But it leaves him little in the way of wriggle room or margin for error.
As sterling plummeted, the Bank of Japan intervened to support its own currency. This was the first time it had done so since 1998 when it attempted to halt a 20% decline against the US dollar. Interestingly, sterling has fallen by a similar amount year-to-date against the greenback. The euro, meanwhile, has always traded below parity with the dollar.
So the Bank of England, the Federal Reserve Bank and the European Central Bank are all aggressively hiking interest rates in a bid to crush inflation. In contrast, the Bank of Japan is steadfastly holding on to its negative-rate policy – even with a tick-up in inflation.
In the US, Joe Biden is relieved that gasoline prices at the pumps are finally falling: West Texas crude has fallen from its peak of US$122 to US$83 a barrel.
But tensions in the energy markets are far from over. As winter approaches in the northern hemisphere, Vladimir Putin's every action will be closely scrutinised. Given the military difficulties he is currently facing, he may be tempted to ratchet up his oil and gas embargoes on the West. By selling lower volumes of oil and gas, he could impose another squeeze on supplies and create further problems.
Europe’s dependency on Russian gas is now making it quite unaffordable for businesses and households across the continent. And governments are finding that energy prices are dictating their economic policies, further complicating things.
Meanwhile, as economies start slowing down, the demand growth slackens. This could create a slightly more positive outlook for supplies. But an unpredictable winter lies ahead.
In the financial markets, we are seeing short-dated bonds – such as 2-year treasuries and gilts – yielding over 4%, while some of the challenger app-based banks are offering a similar cash deposit rate over the same term. This adds to the pressure on global equity markets, against a backdrop of uncertainty surrounding inflation, interest rates, corporate profitability... and a recession in 2023.
Never let it be forgotten that quality businesses with strong balance sheets, cash flow and rising dividends will create shareholder value over the long term. And businesses with pricing power can help offset the ravages of inflation. In recent months we have seen a tremendous contraction in share prices, giving investors one of the best buying opportunities since the Global Financial Crisis of 2007/08.
“Inflation is taxation without legislation”, said Milton Friedman. Growing your assets over a long-term time horizon will prevent your capital from being eroded by that particular silent thief.
