Articles

By Patrick Farrell, Chief Investment Officer and Head of Research, Charles Stanley

Stock markets have fallen sharply. The risk of recession has risen as inflation soared and created a ‘cost-of-living’ crisis for consumers. This has increased the cost of borrowing – and mortgages have become too costly for some. The division between autocratic and democratic nations has increased, putting the global energy supply chain in flux and disrupting the energy transition. Here are some of the major changes – many unpredictable one year ago - that investors need to consider.

Demand – and inflation – unleashed

The defining issue this year in financial markets has been inflation. Stubbornly sitting at multi-decade highs, one of the key drivers of inflation over the past year has been supply-chain pressure. The rapid reopening of economies following lockdowns led to an unprecedented jump in demand for goods – both in absolute levels and relative to services. This phenomenon was particularly acute in the US, where consumers rushed to spend their ‘stimulus checks’ on new durable goods.

Central bankers – not just at the Federal Reserve but all over the world – failed to see the inflation coming – resulting in price rises not seen since the 1970s. There has also been a shortage of workers, as many people decided to remove themselves from the workforce following a pandemic pause. This has added to inflationary pressure as workers demanded higher wages. This means this year has seen the laser focus on employment data increase significantly. Investors pore over US employment data releases to see if it provides any change of the current trends that have led to this tight labour market and hence, define the next actions of the Fed. The worst situation would be a wage-price spiral, where workers demand much higher remuneration to keep pace with the rising costs in an economy. We think this is a low probability scenario given the flexibility in current working environments which is very different to previous wage escalation periods.

Inflation was also given a turbocharge by Russia’s invasion of Ukraine, but more on that in a moment. 

The good news is that supply-chain pressures, as measured by the New York Federal Reserve’s Global Supply Chain Pressure Index (see page 15), have started to ease. We are likely to have already seen the peak in price rises in the US, with other economies seeing the inflation apex in the coming months. We believe that inflation will fall significantly during 2023 due to the action of central banks, but still remain above their target levels, resulting in tighter conditions.

The cost of money

The US Federal Reserve is the most important central bank in the world. It has taken investors some time to accept that it is serious about its intent to keep hiking interest rates – but the message now appears to be getting through that inflation is the primary issue and will be tackled despite any detrimental impact on economic growth or asset prices. 

The Fed interest rate rises have therefore been aggressive, with a series of 75-basispoint (bp) increases already enacted. This jump in interest rates means the cost of borrowing money for business loans, personal loans and mortgages has risen sharply. This has compounded the ‘cost-of-living’ crisis that has put financial pressure on businesses as well as individuals. This year has seen disposable income fall sharply for almost all.

Members of the Fed’s interest-rate setting Federal Open Markets Committee (FOMC) continue to give hawkish statements indicating that rates will continue to remain high in 2023 and a pivot to an easier policy, where rates are reduced, is unlikely for some time.

Bonds

For many years, interest rates have been kept at historically-low levels – first as a response to the financial crisis of 2008/9, and then to deal with the impact of the Covid-19 pandemic. However, this year, interest rates have risen substantially - and government bonds are becoming more attractive as a result. As we go to press, the yield on UK government 10-year debt has more than tripled over the last 12 months.

UK bond yields have risen significantly – only heavily-indebted Italy has seen its ten-year yield rise more than seen in UK gilts. It was following the UK “mini budget” from the new Chancellor Kwasi Kwarteng that gilt yields spiked higher. 

Markets were already fragile because they were absorbing the likely path to higher interest rates around the world. International investors then lost confidence in the outlook for UK public finances, as the proposals from the Government are guaranteed to increase the UK’s already-substantial national debt, but the boost to economic growth that these proposals are designed to achieve is much less certain. This growth will be needed to generate the tax revenues to help pay back the borrowing. 

The fact that UK yields have grabbed the number two slot in terms of annual percentage rises was given a turbocharge. Markets now need reassurance that UK finances will remain on a sound footing and worry about the impact of this fiscal plan on government. One of the more controvertible tax cuts has been reversed and Liz Truss’s government is likely to make further concessions to ensure investor confidence returns.

A fistful of dollars

The US dollar has soared this year against all major currencies for two main reasons – the Federal Reserve’s aggressive interest rate rises and its preference as a safe haven in troubled economic times. This year so far, the dollar index, which tracks the currency against a basket of other currencies, is up almost 17%.

For Americans, a stronger dollar means cheaper imports and bargain vacations. However, it also reduces earnings at US global corporations when foreign earnings are converted into dollars for reporting purposes. This has contributed to the current earnings estimates for these companies looking stretched.

It also weighs on other economies because most commodities are priced in dollars, making necessities like oil and wheat more expensive. The situation is particularly acute in emerging markets, with commodity-producing nations in a much better economic situation than those that rely on importing commodities such as oil, however most are suffering from their own currency depreciation adding to inflationary concerns.

War and energy

The inflation problem was made worse by Vladimir Putin’s invasion of Ukraine, which sent energy prices soaring, as western nations attempted to halt purchase of Russian oil and gas to stop funding Vladimir Putin’s war machine. This year has seen the division between democratic nations in the west and the autocrats, led by Russia and China.

The Ukraine war has impacted world prices of commodities – but it also has isolated Russia from western democracies. Tensions between the US and China over technology transfer – started by former President Donald Trump have continued, and the sovereignty of Taiwan is becoming a serious issue, with tensions in the South China Sea mounting.

The energy-supply issue created by the war also means the energy transition to renewables has been delayed. At the United Nations’ COP26 conference in Glasgow last November, countries committed to reduce emissions, something that has quickly hit the hard reality of energy shortages. Coal-fired power stations are being restarted to substitute for Russian gas. Gas had been classed as a transition fuel in the move to ‘clean’ energy. Russian actions have now delayed this transition. 

What does this mean for the future

As highlighted above, 2022 has seen some dramatic changes. Some of these changes are reversing some of the extraordinary policy settings we have seen in recent years, particularly with regard to interest rates, and are likely to remain, certainly in the medium term. Others like the energy situation will take time for order and balance to re-establish itself between net energy suppliers and users. The larger changes discussed around democratic and autocratic societies represent a changing world order and will continue to have ramifications in the decades to come.