Investing in times of rising inflation
We are all adjusting to weak market conditions and, with the S&P 500 dropping through the 20% downside level in 2022, there are more calls that this is now a serious bear market. Our problem is that the rescue elements of past falls are absent at present. Instead of easing monetary conditions the US Federal Reserve, has embarked on a policy of Quantitative Tightening just when real interest rates are negative and the Fed is promising sharp rises to correct this.
The fear and uncertainty surrounding the current market environment has been well demonstrated year to date by a persistently elevated level in the “fear index” i.e. the VIX. This is a measure of forward-looking volatility expectations and has been higher than recent historic averages, ever since the Russian invasion of Ukraine.
Macroeconomic pressures continue to trouble investors and include (but are not limited to) the Ukraine induced shortage of grain and sanctions on Russia, which have caused a sharp tightening of energy prices at a time when supply was already falling short relative to demand. ESG/sustainable investment influences on energy projects has resulted in falling capital expenditure for new projects and sums now required to bring further supply on stream are substantial. This is the case even in the US, where the relative costs for shale are a fraction of that to extract North Sea oil.
Previous optimism by the US Fed calling inflation pressures “transitory” are now seen as unrealistic and this places huge pressure on the authorities to sharply increase interest rates. The amount that the market will pay for equities is heavily influenced by prime bond yields,. If interest rates should rise to 5%, growth stocks will be particularly affected as a PE ratio of c.20x will be about as much as the market would normally pay. This implies that further weakness in equities is likely as this is a possible ceiling for stocks of the highest quality.
The economic factors mentioned above are likely, in a period of high employment, to result in demands for higher wages. This is a critical factor, as this stage of the cycle tends to result in a rising cycle of higher payments, which only slows when higher interest rates result in rising unemployment. The alarming thought is that there seems to be little scope in any significant area to ease these pressures and protect current equity and bond valuations.
In anticipation of these events developing, we have reduced allocations to equities across portfolios and increased cash positions in order to provide some “dry powder” to deploy into any pockets of value which we encounter over the coming period. In addition, the equity allocations which remain are largely invested in value stocks which should be better placed to reduce any potential further market drawdowns over the coming period. Meanwhile, we have also moved to a significant underweight position in fixed income across portfolios in favour of alternative assets such as infrastructure and property. These asset classes stand a better chance of preserving the real value of your capital in an inflationary and rising interest rate environment (such as the one we are in now), relative to fixed income and this has helped to reduce volatility so far in 2022.
Looking ahead, we continue to look to get on the front foot and are continuously searching for areas of the market which hold promise to swim against the current tide. While the growing consensus view is for inflation to peak later this year and a potential market recovery to ensue, we remain in tricky conditions and continue to manage portfolios carefully. However, history does show that markets anticipate future growth . Financial projections by the Monetary Policy Committee anticipate inflation dropping to low a low single figure in 2024 and we need to be alert to this, as it would be favourable to equity markets.
We would strongly encourage anyone who is concerned about their portfolios, or who has had a change in risk appetite to contact us, in order to discuss the current environment and how we are looking to help protect your capital at present and grow your position over the long term.
STOP PRESS: Boris Johnson resignation
Markets like certainty; initial reaction should be good for Sterling.
The US Fed seems determined to make up for lost time with interest rate rises; these factors should lead to helping contain inflation. We feel this is the key indicator to watch at present and should help bring forward a decent based period for equity markets.
Opinions constitute our judgement as of this date and are subject to change without warning Neither CS Managers Ltd, CS Investment Managers nor any connected company accepts responsibility for any direct or indirect or consequential loss suffered by you or any other person as a result of your acting, or deciding not to act, in reliance upon any information contained in this document. CS Investment Managers is a trading name of CS Managers Ltd, 43 Charlotte Square, Edinburgh EH2 4HQ. CS Managers Ltd is authorised and regulated by the Financial Conduct Authority.