Investment Update
We are writing to provide an update on current market conditions and our thoughts on the strategy that we feel we should be following to provide us with the best chance of success in what is an extremely challenging environment.
The year to date has seen two key issues dominate the news, firstly the war in Ukraine and secondly the sharp rise in inflation; both have caused considerable concern and it is important that we try to understand the impact that they may have on financial assets.
As Mark Twain said, “History doesn’t repeat, but it certainly does rhyme” and with this in mind we have been looking in detail at how past conflicts and inflationary episodes have affected the economy and investments in the past (If you would like a copy of these studies either by post or email, please let us know).
Whilst these studies were undertaken separately it soon became clear that the two subjects were intertwined, and that economic conditions that have prevailed for the last forty years are changing which means we must adapt to this new paradigm.
Conflicts
Looking back to 1973, we assessed thirteen major flashpoints that potentially impacted major powers and found that in most circumstances economic conditions were either favourable, or becoming more favourable, which meant the impact on investments were often short-term.
Whilst the War in Ukraine is for the moment localised, external factors are changing the dynamics of the World Economy; the shock from COVID-19 is being followed by what seems like a new Cold War between NATO and Russia (and possibly China). This means that unlike previous conflicts that we assessed the risk of a wider war is higher than ever before. These factors are also having an increasing impact on the outlook for economic and financial conditions.
Inflation
The UK and US have not experienced inflation at these levels since the 1970’s and whilst there are similarities it is also important to recognise the World is now a very different place. Understanding inflation is difficult and there is no guarantee that the path will be the same as before, even if there are similarities with previous periods.
Central Banks remain in a difficult position as the natural response to high inflation is to raise interest rates, but to do so would choke off economic growth that already remains weak. Whilst some of the inflationary pressures are potentially temporary, the ultra-low interest rates, debt burden, low unemployment, wage growth and a reversal of globalisation suggests that inflation could not only be higher in the short term but also higher for longer.
What should we be doing?
These twin risks pose a major obstacle to the stock market and fixed interest market; both of which are at high levels of valuation that reduces the potential future returns and makes them prone to sharp reversals on any bad news (as we saw in the first half of 2022).
Index-Linked Gilts provide a good example of the complexities of investment decisions; long term we expect these to provide consistent and boring returns yet as inflation has risen in 2022, they were the worst performing assets in portfolios! The reason for this was the rise in interest rates – something that has not happened for a long time - that had a bigger impact on their values than the rise in inflation.
In the coming weeks we expect to be making recommendations to rebalance portfolios into a combination of assets that we hope will continue to provide protection and the prospect of a reasonable rate of return.
Whilst we do not anticipate adding new investments, there will be some changes to the existing assets that we hold.
Intuitively during inflationary periods investors can feel cash is a high-risk investment as the value can be eroded; however, it is worth remembering the in nominal terms (excluding inflation) cash does not lose its capital value. In the mid 1970’s the nominal returns from cash were 11% when the stock market crashed losing -54% of its value in nominal. If we adjust for inflation in real terms cash lost -14% but stocks a whopping -77%. With the stock market at high risk levels, we feel that a cash reserve is the lesser of two evils at present and at the same time ensures we have capital to deploy in market declines.
The US equivalent of Index Linked Gilts, called Treasury Inflation Protected Securities, offer a far better hedge on higher inflation and are less sensitive to interest rate changes than their UK counterpart. Whilst they are not “cheap” they are not “expensive” and offer the potential for consistent if unspectacular returns.
Gold is affected by several factors including interest rates, inflation, the US Dollar, and Stock Markets. In the last year or so returns have been mediocre due to the headwind of rising interest rates and a stronger Dollar; however, this may be about to change and if it is accompanied by equity market volatility, we would expect a significant rise in prices.
Whilst commodities have fallen back in the last few months, we feel the rise in prices could just be getting started after almost a decade of underperformance. The same looks true of the energy & resource sector; in the 1970’s after falling over -60% in value when inflation hit hard the subsequent rally was spectacular. Having declined in value by a similar amount in 2020 during Covid-19 the fundamentals for this sector of the equity appear positive.
We cannot of course guarantee success, or eliminate fluctuations in value completely, what we do hope to do though is to follow strategies that offer the highest probability of success in helping you to achieve your investment goals and objectives.