The investment market seems to be the gift that keeps giving – in the unwelcome surprise stakes. Malcolm Norris, from our investment committee, explains why it has been a challenging time for all, with 2022 proving to be a tumultuous time for investments with the latest asset class to hit the headlines being government Bonds and Gilts.
How did we get here?
Looking back over the last couple of years, we had the covid pandemic in early 2020 when stock markets sold off heavily – but temporarily. Yet by the end of 2020, into 2021, the markets, for the most part, had recovered to their pre-Covid levels.
Indeed, investment markets continued to push forward and generally were looking well recovered and relatively rosy by the end of 2021, coming into 2022.
Since then, however, things have taken another turn for the worse in global economic terms, caused firstly by the growing energy crisis exacerbated by Russia’s invasion of Ukraine in February, sending inflation rocketing.
For a period during the summer, ever so gently, it felt like we were turning a corner. However, in recent weeks we have seen further deterioration in inflation expectations (i.e. inflation looks like it will stay higher for longer than first expected). As a result, central banks (whether in the US, in Europe or at home in the UK) have had to take increasingly aggressive measures by increasing interest rates in an attempt to get inflation ‘choked’.
We will likely see further interest rate rises later this year and into 2023 – the interest rate ‘medicine’ needs to be stronger! This is already ‘priced in’ as you will see in the press that mortgage rates have topped 6% in the UK and are at similar levels in the US.
Closer to home
The situation in the UK has been pretty grim over the last few weeks. Particularly since the installation of Liz Truss as Prime Minister and her ‘rabbit out of the hat’ tax giveaways concerning taxation and borrowing in the then-Chancellor Kwarteng’s mini-budget. Which, as we all know, has since needed to be scrapped.
It could be argued that the PM was clear all along about her intentions during the Conservative leadership contest. The markets reacted particularly badly to the actual implementation announcement of the Government’s plans for tax cuts which were going to have to be funded – in part at least – by increased borrowing at much higher rates of interest due to the aforementioned interest rate rises.
The market view was that increasing UK Government borrowing – to fund tax cuts – at this time was fiscally questionable.
Don’t throw the Bonds out with the bathwater
We have since seen – as expected with the rising cost of living – not only a fall in world stock markets but a significant worsening in interest-rate expectations leading to a significant sell-off in bonds (whether US Treasury bonds, UK gilts or corporate bonds).
In other words, markets saw the UK as a higher-risk creditor. As such, the interest rate demanded on UK debt went up. Indeed, the Bank of England had to step in and support the Bond market for a period of time to support UK company pension funds, which were then heavily stressed due to the need for them to hold these assets to match their liabilities. Following the appointment of the new Chancellor, Jeremy Hunt, and his reversal of most of the planned tax cuts, there are early signs of some welcome stability in the UK Bond market.
Typically, bonds (essentially a type of fixed-interest investment) are viewed as relatively safe and act as a bellwether against stock market volatility. However, we are currently in a “perfect storm” of difficult market conditions for stock markets in the face of likely recession, added to this has been tumbling bond values as their capital values have fallen as a result of the rise in interest rates.
As a general guide, most portfolios hold a combination of stocks and bonds, but neither asset class has been immune from market sentiment in recent months. Consequently, portfolios – even relatively cautious or defensive ones – will be in a challenging position at the current time. But it is important to understand the background as to why these events have happened and why they will have impacted adversely on most portfolios.
At that time UK and US Governments were combating high inflation. As a result, we saw a similar shock to investment markets and bonds specifically, caused by a ‘medicine’ of a series of successive interest rate rises. However, there is a crumb of comfort in that both stock markets and bond markets went on to recover their losses and push on to gains once the central banks’ interest rate-rising policy had got inflation under control.
What is the outlook?
The Bank of England currently expects inflation to peak in double digits either later this year or early next year, possibly as high as 10% or 11% depending on the success of the energy price cap. But interest rates will have to continue to rise for some time yet to be certain that inflation is brought back under control.
Consequently, the market is pricing in interest rates that will reach 5% or so within the next few months. The situation and outlook in the US are similar, although they are a little further down the rate-hiking track. However, we do believe that these anticipated rate rises are already “priced in” to the value of equity and bond markets, therefore unless there is much further bad news in the near future we can hope that we have seen the worst. Therefore, our guidance would be to hold on and tough it out in the hope (nay expectation?) that the Bank of England (and the Federal Reserve in the US) get it right and that we do see inflation brought under control.
The Bank of England’s target1 is for inflation to be back at around 2% in around two years time, consequently for interest rates, once they peak to level off and start to fall back to more normal levels.
Once the markets have confidence that inflation is under control we would expect to see a recovery in both equity and bond markets, which would, of course, have a positive rebounding effect on portfolios.
We hope this helps explain to some degree what has been happening in the markets, especially in these volatile times over the last couple of months – principally since the (now largely unwound) mini-budget of 23rd September.
It is quite an unsettling time, we appreciate this, but we will continue to monitor your investments as required and advise you if we feel any changes should be needed. It is unlikely we would advise clients to crystallise or sell investments when they are in a disadvantageous position, normally, we would counsel you to hold on for the markets to recover.
We very much hope this helps put the current global economic situation into some form of context. However, please don’t hesitate to contact your adviser if you have any queries.
This article should not be interpreted as specific advice. As always, we would urge you to contact one of our specialist advisers, who will look at your own circumstances before advising.