As the months have progressed throughout 2022, it has become apparent that we are living through a unique economic environment.
There have been many counterintuitive moments where traditionally positive events have caused a fall in asset values. Inversely, traditionally negative events have resulted in rapid market rallies.
What is inflation?
At its core, inflation is still a big worry, and those most fearful of inflation are comparing current events to a replay of the 1980s. The phrase, “history does not repeat, but it does rhyme”, is bandied around by market participants daily.
Inflation went from supposedly being “transitory” to being much stickier than economists hoped. The biggest worry being we will have year after year of inflation around 10%.
The tools central banks have at their disposal to tame inflation are primarily interest rates.
Why does inflation occur?
The notion being that if interest rates are increased, borrowing is more expensive, and saving is more attractive. Therefore, they hope people will borrow less and save more, spending less money in the economy and controlling inflation.
Inflation is the illness, and interest rate rises are seen as medicine, despite the severe side effects.
For the last 10 years, central banks have kept economies strong with the help of quantitative easing. In short, this involves central banks printing money and buying government bonds. The more government bonds are bought, the higher their prices rise and the lower their yields.
When yields were pushed to close to 0% during the height of the Covid-19 pandemic, new government bonds were issued with equally low interest rates.
Central banks have not only stopped quantitative easing, but they have begun quantitative tightening, which involves selling the assets they bought. The more they sell, the lower the price goes, causing yields to rise.
Inflation and Global bonds
This has wreaked havoc on global bond markets and Defined Benefit (DB) pension schemes in particular. DB pension schemes are some of the largest holders of government bonds and their portfolios have been hit hard by quantitative tightening.
The bond market is the second-largest global financial market. In comparison with the stock market, the bond market is an order of magnitude larger. As such, a potential bond market downturn damages almost every aspect of global financial markets.
What we are experiencing at the moment is the worry that if employment is low, wages are rising, and businesses are profitable, inflation will stick around much longer than if economies were weak.
Therefore, markets rallied on news that unemployment had increased but then dropped back down when wages increased above consensus.
During normal times, wage increases should be positive and increasing unemployment should be negative. However, these aren’t normal times, and the inverse of the traditional narrative seems to be how things are playing out.
This makes it very difficult to get an understanding of what we need to happen before things return to normal, and for markets to recover. When things get confusing, we always return to our principle of holding high-quality real assets and investments that can weather the storm and will come out of the other side more developed and successful.
Warren Buffett often recites the story that if a neighbour turned up to your house every day, knocked on your door and told you how much money they’d give you for your house, there would be some days when their offer would be offensive.
The stock market can be equally offensive; offering well below fair value for assets that will no doubt recover and appreciate given sufficient time.
In the same way you would shut the door on the neighbour if their offer was clearly less than the house was worth, you shouldn’t part with any assets at a time when markets aren’t valuing them fairly.
Our message is always clear: your portfolio is of the highest quality imaginable, globally diversified, and tax efficient. Sitting tight will pay dividends in the long-term.
We completely understand that this year has been tough, and there is no escaping it. But we will always be here to help you get through challenging periods, help explain what is happening and how to steady the ship so it remains on its course.
NewsJuly 19, 2012
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