We could be entering an era of much higher inflation, interest rates and stock market volatility. We look at what it means for the economy and your investments.
The inflationary tide has finally turned: data released today by the Office for National Statistics (ONS) reveals that consumer price inflation (CPI) inflation dropped from 10.7% to 10.5% between November and December, having peaked at 11.1% in October 2022.
It’s easy to forget that just over a year ago, we were at the end of a long period of low inflation and ultra-low interest rates. As recently as July 2021, inflation was 2.0%, the average level over the 29 years between January 1993 and December 2021.
As experts predict higher inflation could continue for at least a decade, we take a look at what a higher cost of living and interest rates means for the stock market and investors.
Period of ultra-low interest rates and inflation
It’s important to remember that the past 30 years have been very unusual in terms of inflation.
Looking back over history since 1949 shows that RPI inflation averaged 6.9% between June 1948 to December 1992. In contrast, it averaged 2.2% between January 1993 and December 2021.
And the last few years, after the 2008 financial crash and then the Covid pandemic, have been even more unique. After 2008, central banks pursued a long-term policy of ultra-low interest rates to try and boost lacklustre economic growth.
Then, during the Covid pandemic in 2020, central banks dropped interest rates to almost zero as they tried to boost their economies and counteract the impact of lockdowns. The Bank of England base rate reached an all-time-low of 0.1% in March 2020.
A stock market bubble is more likely when there are low interest rates. Ultra-low interest rates mean that valuations for growth companies are high: future profits are discounted using future expected interest rates. If interest rates are virtually zero, then profits expected in 10 years are worth almost the same as today. This means companies where valuations are largely based on future profits have higher valuations when interest rates are low.
In addition, low interest rates make cash investing relatively unattractive and encourage more investment, cash returns lagging far below those of stocks and property investment.
But in 2021, inflation started to build, first producer price inflation, and then consumer inflation. Beginning slowly, producer price inflation, a measure of wholesale inflation, rose from -0.3% in November 2020 to 10.3% in May 2021 and 19.1% in March 2022, peaking at 24.2% in June 2022.
CPI followed behind, rising from 0.3% in the UK in November 2020 to 2.1% in May 2021, 5.5% in January 2022 and 11.1% by October last year.
Central banks then began to increase interest rates in an effort to bring down inflation - the Bank of England increased the base rate from 0.1% in December 2021 to 3.5% just a year later in December 2022.
The silver lining is that many experts now believe consumer inflation has peaked and will gradually fall during 2023. Energy wholesale prices, a major inflation driver, have plummeted in recent weeks, dropping to their lowest level in 16 months.
Energy analysts Auxilione commented that, “the lack of cold weather in the long-term forecasts, supported by a string of LNG cargoes expected in the coming weeks and EU storage levels still above 80%, are giving markets the confidence that 2023 has an opportunity to be very different to last year”.
The price changes will take a while to filter through to households as most energy is bought months in advance through forward contracts.
What’s next for inflation?
Continuing high inflation means the Bank of England is under pressure to further increase interest rates when the monetary policy committee (MPC) next meets in early February.
The Bank of England’s mandate is to use monetary policy to keep inflation below 2%. But interest rates are a blunt instrument, and the effect takes many months to feed into the economy. And there’s also a serious risk that raising interest rates too high could force a deeper and longer recession.
Is 2% inflation a realistic long-term aim for central banks?
Duncan MacInnes, fund manager of Ruffer Investment Company (LSE:RICA) believes that we’re likely to see higher and unpredictable inflation for some time. Speaking to collectives editor Kyle Caldwell, he revealed that he expects inflation to be much more volatile in the future. He commented that, “the last decade had 2% inflation with very little volatility around that. The next decade might have 3% or 4% inflation on average, but with 10% inflation like today and some periods of lower inflation, zero inflation or deflation.”
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And research last year from Bank of America showed that once “the inflation genie is out of the bottle”, it takes a long time to get back to normal.
A team of analysts studied inflation in advanced economies from the 1980s to 2000s and found that on average it took 10 years to bring inflation down to 2% once it rose above 5%.
What does continuing higher inflation mean for the stock market?
If MacInnes and Bank of America are right, then we could be in for a long period of inflation, interest rates and stock market volatility.
MacInnes believes that we may not yet have seen the bottom of the stock market dip.
He explains that, although, “the stock market's down a fair bit, it's really come down because of interest rates going up” – and the valuations of growth companies dropping as a result. But a recession could push the stock market lower because S&P 500 earnings forecasts look, “way too optimistic”, in a potentially recessionary environment.
MacInnes also believes that liquidity issues may cause stock prices to falter if there is a widespread “de-risking” of portfolios as people choose “to sell up and go to safer investments”.
He explains that liquidity issues are often overlooked as a driver of stock market prices. “You have this dynamic where people are moving funds from banks to money market funds. Now, that does not sound like a particularly consequential event, but I assure you it is. Basically, it's because banks have a money multiplier and that money gets fired around the system and re-lent to corporates and so on. Money market funds deposit their money directly with the Treasury and there is no multiplier in that. So that [is] another source of significant liquidity being drained from the system. That leaves markets very vulnerable, we think.”
Move over ‘TINA’, it’s time for ‘PATTY’
For investors, it’s an important reminder to think about your time horizon and make sure your portfolio matches your investing goals.
Investors who are still 20 years from retirement can afford to take more investing risk as they have more time to ride out stock market volatility. In contrast, short- or medium-term investors need to look at their asset allocation and plan ahead for income they need in the five years.
As for the specifics, many experts believe that bonds currently offer good value, particularly for medium-term investors.
MacInnes explains that the fall in bonds prices has given investors and fund managers a potential opportunity to make money from bonds. Rather than “TINA” (there is no alternative to equities), fund managers are now talking about “PATTY” (pay attention to the yield).
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But it’s not just the yield that’s important as different types of bonds have different risk profiles.
MacInnes warns that although high yield or investment grade credit yields look attractive, “our concern there would be that the economic deterioration could cause a lot of trouble there. Again, those spreads have not widened that much. They've fallen in price because the interest rates have gone up, not because the credit spreads have widened. Our buying has been very much focused on US inflation-linked bonds, which, as I said, offer inflation plus 1.8%. I think over the next 20 or 30 years that is arguably the safest investment in the world, and it's finally offering an attractive rate, the best rate it's offered in more than a decade.”
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