The party's over?

Market wrap

Stock markets continue to digest the sharp move higher in real interest rates this year

Nonetheless, real interest rates remain in very generous territory relative to a global economy that has recovered briskly from 2020 lows

The outlook for inflation remains highly uncertain and a source of intense debate amongst investors and central bankers

CIO view

The sense that central bankers are trying hard to push the world into a very different paradigm for monetary policy remains. Thanks to the interplay of expected inflation and expected interest rates, the monetary accelerator remains firmly on the floor in real terms, even after the violent move higher this last fortnight. Incoming economic data suggest an increasingly urgent need for less stimulus. Jobs markets around the world appear to have healed far more swiftly (and painlessly) than many had feared. Meanwhile, incoming information on inflation points to ongoing mismatches between demand and supply in several important areas.

Some of the factors that are boosting inflation at the moment are surely temporary – part of the various one-off adjustments to supply and demand forced by the pandemic and the many resulting changes to our wants and needs. The question that will go a long way to dictating which areas of the capital markets universe triumph (and don’t) this year will be what inflation remains when these temporary factors recede??Are we entering a new era of more problematic inflation? Has the beast tamed so successfully by the legendary central banker Paul Volcker (among others) been released from its cage? No matter where the trend in inflation ends up in the years ahead, this year may provide data points to buttress this argument. Demand for workers is likely to continue to materially exceed the available supply for some time to come, supporting wages. Meanwhile, Omicron is still plenty capable of re-inserting some havoc in global supply chains as it searches for chinks in China’s zero-Covid armour.

For those investors sympathetic to this view, the first couple of weeks of this year provide an interesting (if perhaps extreme) template for what to expect from capital markets. It’s been some time since investors have had to incorporate a central bank community actively trying to squash inflation, rather than boost it. The investor playbook for such a world is pretty dusty as a result.

At the other extreme are those arguing that this time is no different. The deflationary tendencies of the last decade or more have not disappeared. This pandemic, like many of its predecessors, will durably weaken risk-appetite amongst consumers and businesses. Savings ratios will rise and it will not be long before central bankers are again battling deflation with everything at their disposal. Therefore, stick with the mix of investments that has triumphed so spectacularly over the last few years and beyond. Any short-term pain is simply an opportunity to re-establish positions in the ultimate winners.

This is, of course, an oversimplification of the market debate at the moment. However, sensible investors will admit that we can know very little about the outlook for inflation beyond this hump. As usual, strong views should be taken as a sign to tune out, not tune in. The path of inflation is plenty capable of continuing to defy academics, text books and central bankers alike. This is part of the reason why the team here spends so much of its time designing and implementing diversification in the multi-asset class funds and portfolios we build for you. In a world that still (surprisingly) seems in thrall to high conviction leadership, diversification can seem mealy-mouthed, pointless even.

However, an honest assessment of what about the last few years you, or those you chose to listen to, got precisely right should help. This humble starting point for the organisation of your diversified investments does not mean that we do not have views. However, the sizing of the various carefully shaped tilts we put in your portfolio, both at the security and index level, is designed not to dominate overall returns. At the moment, we still see sterling as vulnerable for example. Stocks in aggregate look interesting on a very short horizon, emerging market local currency and junk debt less so. We deliberately hold value, as well as growth, funds – something that has dragged on performance over the last few years. We remember well that it was only a few years ago that many commentators were wondering when the value bubble would pop and whether growth investing would ever return. That the reverse has been true these last few years speaks of a trend in the prevailing macro, political, and regulatory context that could easily be about to change.

Uncertain times lie ahead, as they always do. There is an argument to say that this is among the more uncertain moments of the last few decades, maybe more. We have changed, and the world economy with us. We just can’t really see how much yet. In this context, the allure for investors at the moment is not in some promised near-term stock, sector, or asset class outcome – positive or negative. It is associated with the growing sense that the productive spurt of the last few centuries, following millennia of stagnation, is just the beginning. Our collective store of useful knowledge continues to grow rapidly behind the scenes. Thanks to advances in artificial intelligence, some of this growth is moving beyond our ability to explain with theory. We can never know how or when this growing store of understanding will next pay out meaningfully. However, the point of investing is to be ready and waiting. History tells us the wait will be worth it, providing you don’t get sucked down too many high conviction rabbit holes.?

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*This article is for information purposes only. It is not intended as a product offer or investment advice