Falling stock and bond markets, along with the rising volatility which has gripped global markets since the start of the year, has intensified in recent days. Last week’s announcement of annual US inflation of 8.6%, the highest in 40 years, was the primary cause.
Energy, food, and services have all contributed to the rise in US inflation. Reduced supply and increasing demand factors are pushing prices higher. Regarding energy, there has been significant supply constraints due to the conflict in Ukraine along with greater demand as the US holiday driving season ramps up. Food prices have also been affected by the costs of production (increased fertiliser costs) and transportation. Services costs have risen as demand increases as the economy reopens and consumers recommence travel and other related activities. In the last three months alone, airfares have risen 48%.
We appreciate that the current environment looks concerning given falls in markets and likely further interest rate rises. There have also been reports comparing the current period to previous episodes of rising inflation and interest rates. It is worth examining two previous periods of rising inflation and interest rates. These two periods are the 1970’s through to the early 1980’s, and 1994. Whilst it is difficult to make direct comparisons as the global economy and markets have evolved since these periods, it is still worthwhile to identify similarities and differences which can assist in thinking about the market outlook. In the 1970’s, economies were impacted by oil price shocks, causing inflation to surge. Geopolitical issues in the 1970’s were mainly responsible. As a result, central banks at the time were much more strident in taming inflation, and rates moved well into the double digits. In the US interest rates reached 20% by late 1980. This resulted in the recession of 1981-1982, and US unemployment reached nearly 11% in late 1982. However, economies were much more rigid at that time and the rising inflation resulted in significant wage rises becoming much more entrenched. This is not the case today. As labour markets have become more flexible in recent decades the likelihood of wages increasing at the same rate is diminished.
The Fed also embarked on a series of interest rate increases primarily to ward off inflation in 1994. However, there are a few key differences with now. In 1994, whilst inflation was rising, it hadn’t risen to the current levels. Policymakers, however, fretted that a strong economy would translate into much higher inflation. The Fed doubled interest rates over a 12-month period to 6% – at one point executing a three quarters of a percent hike. The speed and degree of the rate rises took markets by surprise and resulted in significant drawdown in fixed income markets.
Current economic conditions today are more sensitive to interest rate movements, given higher indebted levels, an ageing demographic, slower population growth, and lower economic growth. Central banks are aware of these conditions and as a result, whilst seeking to reduce inflation, will also likely be conscious of the market impacts.
Importantly, we do see inflation likely moderating over the next 12 months. A range of factors particularly around supply side constraints such as ongoing Covid impacts particularly in China and energy prices have been key drivers in the current inflation numbers. We expect these constraints to ease in coming months. This in turn would likely improve the outlook for rates, bond markets, and equities.
In addition to Geopolitical factors listed above, we see that the current inflation environment has been largely caused by massive increases in the money supply just after the Covid crisis. Two and a half years later, the lagged impacts of those money supply increases are showing up in rising prices for goods, services, real assets and commodities.
As the Covid crisis unfolded and the world controlled the situation, the growth rate in money supply was drastically reduced. This may mean that large increases in inflation this year may be followed by a moderation in prices in 2023 and beyond, as the lagged effect of those subsequent money supply decreases flow through next year.
What to do?
The volatility that we’ve seen over the last six months, while significant, is not an unusual occurrence for a normal and healthy functioning market. Despite being an uncomfortable experience in the short term, equity markets will continue to be an important contributor to overall long-term returns.
It is important to continue to stay invested and manage your portfolio in line with your long-term objectives, aligned to your risk tolerance. We would encourage investors to discuss their portfolio with their adviser to ensure that it meets their personal needs, objectives and is in line with their risk tolerance.
One of the important lessons in investing is that time in the market, is more important than timing the market. As we continue working through this period of heightened volatility, keeping the longer-term in mind remains important.
Disclaimer: The information in this report is general advice only and does not take into account the financial circumstances, needs and objectives of any particular investor. Before acting on the advice contained in this document, you should assess your own circumstances or seek advice from a financial adviser. Where applicable, you should obtain and consider a copy of the Product Disclosure Statement, prospectus or other disclosure material relevant to the financial product before making a decision to acquire a financial product. It is important to note that investments may go up and down and past performance is not an indicator of future performance