Out of the frying pan and into the fire

Can rising interest rates curb inflation?

13 May 2022

Our Chief Investment Officer talks about recent interest rate rises, the latest on Ukraine, and China's coronavirus (Covid-19) outbreak.

The current landscape

In the US, the Federal Reserve raised interest rates by 50 basis points and we expect further rate rises on the horizon. However, there have been tentative signs that inflation may be peaking in the US. The big question for investors at the moment is: to what extent will the US central bank accept slightly higher inflation in order to avoid forcing the economy into a recession?

Meanwhile, the Bank of England’s Monetary Policy Committee also raised interest rates. However, sterling has depreciated as investors contemplate how many more interest rate rises the UK economy can actually absorb in its current state. As a peak in inflation in UK and Europe is not expected until much later in the year, consumers are likely to experience a tough summer ahead as oil and energy prices sap disposable incomes.

Elsewhere, there are some very welcome signs that the current wave of Covid may be peaking in China. However, the economy is far from out of the woods yet and we are likely to continue to see snap lockdowns as policymakers continue to battle this much more transmissible variant.

In terms of portfolio positioning, we’re slightly more cautiously positioned than we were a month ago. Our short term mix of positions will profit if emerging market equities continue to underperform compared with their developed world equivalents as the global economy slows. Meanwhile, we continue to be a little cautious on sterling, even after the sharp falls of the last month.

As always, we recommend investors get invested, stay invested, and stay diversified.

PHIL ATTREED: Hello and welcome to the May episode of Monthly Market Insights. I'm Phil Attreed, Barclays Head of Wealth Specialists. And once again, I'm joined by Will Hobbs, our Chief Investment Officer.

Now, it appears we're set to remain in a relatively disorientating period for the world economy and for the investment markets that reflect what is a rapidly evolving outlook.

Central bankers are raising interest rates in a way that we haven't been seeing for decades as the battle obviously against inflation has stepped up several notches in recent months. So much so that actually many are now worrying about any forthcoming or the next recession.

So we're talking a little bit about that today, Will, also the latest on Ukraine and obviously the evolving situation with China's Covid outbreak as well.

So maybe we start with the central bank piece. We've had Bank of England and the Fed raising interest rates this week. You're even seeing interest rate rises drawn nearer in Europe as well. Will, have we learned much new from this information over this week or so?

WILL HOBBS: It's a good question, Phil, a good starter for one as they say. I mean, you're right and your introduction just saying, viewing, as you and I know well, we've said this before, but viewing markets through the prism, viewing the world through the prism of capital markets is a disorienting experience at the best of times and these are not they.

But from a central banking perspective, let's start there like you say. In the US there was a bit of a very, very short-lived relief that the central bankers didn't go with the 75 basis point, they just went with the 50 basis point rise.

That point alone illustrates how far we've travelled in terms of rate expectations so far this year. It continues as a result to be a horrible period for government bond investors, traumatic even, really a change in what most government bond investors have experienced in the last few decades.

In the US you are likely to see more coming as well. There are still more 50 basis points rate hikes expected and as we've been discussing on 'Word on the Street', there are maybe some signs in the US that inflation is peaking a little bit.

Certainly you are going to see over the summer some incredibly muscular forces trying to drag inflation back towards the ground a little bit. It's certainly those, as we lap those, the effects of those stimulus checks that should be a significant influence pulling inflation forces down.

However, the big question really at the moment is, amongst bond investors and central bankers a little bit is: to what extent will the US central bank accept slightly higher than previously seen inflation in order to avoid crashing the economy? And this like you say, it's the other big market narrative at the moment.

Are all these interest rate rises, are they going to run the economy into the sand, US and global?

PA: And I know we're humble enough not to make any hard predictions here. But are we seeing any chances of the next recession evolve, is that something that you and the investment team are looking at, thinking about?

We hear lots of seemingly credible commentators talking about how it's unlikely that we can avoid a recession given both the interest rate rises that we've had but also those that many are obviously predicting in the months ahead.

WH: Yes, one of the many lessons you might take from the last few years, you and I, is that you don't want to get too busy rubbernecking the political and economic accidents in the road ahead. What will be will be and investment markets don't always behave as you might expect in those circumstances.

And anyway at the moment, the point we'd make to clients, as you know, is that your eye line should be well above the next recession if it's a year away, let's say.

But I think on this point specifically, yes, interest rates are a very blunt tool and usually do come with lots of unintended consequences. So, some indication of that could be seen in the fact that actually since the 1980s, that was when you saw the so-called Volker shock. So Paul Volker, the legendary central banker in the US, tamed inflation by raising interest rates to 20%.

Now since then, actually you've seen that there's not much of the co-movement that you might expect or much of the relationship you might expect with regards to interest rates and inflation. You might expect as interest rates rise; inflation falls because that's the intention of interest rates.

They're meant to slow aggregate demand and re-plug aggregate demand into aggregate supply, the available supply in the economy and so get price pressures under control a little bit, get everything travelling in equilibrium.

But actually you find weirdly that inflation and interest rates have often travelled in the same direction for periods of time. So you can find that rising interest rates comes with rising inflation.

Now, the point here again is a little bit of humility, because what you can find is that interest rates can – for a load of reasons – affect both demand and supply, and therefore the relationship is really complicated.

I think what you're seeing at the moment in the US, that's the other thing to bear in mind is it's not gentle. These are not the interest rate rises we've become used to in the last few decades. This is something the Federal Reserve is trying to engineer, a materially tighter kind of monetary backdrop in quite a short space of time.

Demand for everything has to cool quite rapidly, workers included. So you should see unemployment rise and those kinds of things. So yes, there are risks and there's many very garlanded names talking about the risks of a recession.

But as an investor, I guess the key point we get to and I'm sorry, waffly long answer as usual but the key point what we do as investors. Now, I think there’s probably two things. One, and again, this is the point we've made before but this is where the word “recession” is not that useful. It's similar to “cake” or “dog”.

There are many types of dogs and cakes – some friendly, some less so on both cases, and it simply doesn't tell us that much useful for an investor because the word refers to such a broad range of experience from the economic horrors of 07/08 to recessions which don't really even have a name because they’re statistical only.

We could take some consolation from the fact that the worst recessions in the past have tended, not always, tended to be preceded by a build-up in economic success. And therefore you need the purgatory forces of a recession to come along and correct those imbalances. That's not the case that we see right now.

So actually, which gives you, on to your second point, the US – and this is, remember, the motor for, the keystone for the world economy – the most important capitalist economy by a mile. The US enters this period still in really very robust health with lots going for it, particularly the private sector, companies and businesses. The balance sheet health is sensational, so you have got a lot going for it.

But it's a complicated time for investors. There's no doubt about that. And what you're seeing in the bond market at the moment, which I think is so interesting is that you're seeing investors suddenly start to look at compensating longer-term lenders to the government for a bit more risk of inflation, which is an important moment, I think. Sorry long-winded answer hopefully you get the idea – don't worry, focus on other stuff.

PA: I’ll remember the analogy anyway, the cake and the dog analogy.

WH: The two things on my mind!

PA: How is the situation maybe a bit different in the UK and for Europe?

WH: Yes, it's a lot different in the UK and Europe. Some of that strength is just not there, particularly in the UK. The latest data points in Europe, the services sector is still showing some sort of recovery from the Omicron blows. But the problem there of course is you're seeing in the last couple of weeks is this gas supply story.

There is still the potential for that to be cut off and that would plunge the European economy into economic darkness for a short while. The damage would be most grievous on those sectors that are most reliant, so paper industry and so on, on gas supplies, and you're seeing accelerated plans to try and wean the economy off that Russian gas reliance.

And in the meantime, you're seeing this debate go on – you've seen the discussion about the currency that Russian companies want to be paid in and this debate about, it's been taking up Poland and Bulgaria in the short run. So, there is that concern that could really change things quite quickly. In the UK, we've had the Bank of England this week.

And I mean it's interesting, but the market had been expecting quite a lot of the Bank of England in the months ahead and you and I discussed this on 'Word on the Street' and other media over time, the team have long believed that the market is being too optimistic or expecting too much of the economy in the idea that it can take so many rate rises without swooning, without aggregate demand really plunging and that is proving to be the case today.

So you've seen an interest rate rise from a very conflicted Monetary Policy Committee. It's not of one mind at all, but you've seen that and the market is burying sterling because what you're seeing across the bond market is that the market has taken out one rate hike so far but that is really in deference to the idea that the UK economy is too weak at the moment and for the next few months ahead to be able to take much in the way of the rate rides as you're going to see or should see, or likely see in the US.

And in the UK and Europe, whereas you are seeing a peak or potentially a peeking inflation in the US, that peak looks to be a bit further away in the UK, you're seeing the regulator is going to give us another gift sadly, particularly the poorest households towards the end of the year, so you're not going to see a peek in inflation in all likelihood until much later on in the year.

And you've got this very tough summer ahead in terms of real disposable income with these, oil and energy prices really sapping the consumers’ strength. So tough times ahead for the UK. There's no doubt about that.

And that is why you're seeing very different market reactions, but happily, although obviously we're vested in the UK economy doing well, the team is necessarily dispassionate so far that's been a good position in portfolios to be underweight in sterling relative to G10, its G10 peers, and that's making money for the portfolios today.

PA: And to complete the global picture, we shouldn't forget China. It's been a very tough period for China year to date we've seen the first material Covid outbreak since the beginning of 2020 there, the economy was already fairly wobbly. So are there any concerns of worsening there and what that might mean in terms of knock-on effects?

WH: Yes, it's a good question, Phil. There are some very welcome signs that this current wave of Covid is peaking, many may be a little bit wary maybe understandably of the case data, but if you look at mobility statistics and real-time data, you can see some improvement suggesting that some of the lockdowns are easing.

The economy is far from out of the woods though as we've been saying, the problems highlighted by the property market blow up of last year, the Evergrande affair, they remain, and you are still seeing and will likely see for some time yet snap lockdowns as China's policymakers continue to battle this much more transmissible variant. I think that's the main thing.

But China is just not as important for the world economy in its capital markets than the US, and we all want China to do well, we all want the world economy to do well. But it's just less important from an investor's perspective.

The other point to make here just from a portfolio perspective is that we are actually underway EM (emerging markets) equities relative to DM (developed markets) equities. So again, China's plight is being a little bit helpful, even though we are necessarily dispassionate but that again has been helping portfolio performance.

PA: And I suppose lastly on that point, are there any particular changes to positioning that you and the team are considering amongst all of what we've just talked about?

WH: Yes, the main one that's been put on this month has been, actually we've taken out a net overweight to developed equities and replaced it with a relative value trade between development market equities and emerging market equities.

So your overall package of positions in the Tactical Asset Allocation (TAA) is probably slightly negatively tilted in terms of bad news being better than good. But not materially so but as we entered this period we thought that strong directional views are probably not the way to go and so have moved into that relative value area a little bit more.

The other one, which we're watching very carefully obviously, is that open sterling position. It's now moved, some distance from where we put on the trade so it's just one to watch.

I think there's a lot of data coming up; there's a lot of stuff happening in the world economy in the coming months, outside of the unpredictable unknowns of Ukraine, you've got giant forces pushing and pulling the global economy.

You've got this central bank context we have not seen for decades. So it is a really interesting time to be an investor obviously and this is where the team does their best work, so that's the good bit.

But otherwise, we must hope that the various people suffering the various blows around the world economy, from financial to healthcare – that's something we hope moves on quickly and we get to better times.

PA: And of course your reference to being slightly negatively tilted assumes that a client is already fully invested. So, it's absolutely not suggesting that we should be negative. But that actually that's a negative tilt to a normal position.

WH: Phil, that's a very good point to finish off on because obviously the size of the positions relative to your overall asset allocation, the Tactical Asset Allocation is tiny. We could only necessarily muster small confidence in those kinds of views, really it continues to be the Strategic Asset Allocation that you need to take solace in.

That's where it's got diversified commodities and all sorts of other assets to be able to smooth your journey and that continues to do pretty well in the current backdrop, but that's really where the meat and drink of your portfolio returns is. The TAA just looks to provide a few class-A cherries, let’s say.

PA: Fantastic. Thanks. Useful as always, Will, and thank you to our viewers and listeners for joining us today. If you would like to keep in touch with our views over the course of the next month, please do check us out on our podcast 'Word on the Street'.

Out of the frying pan and into the fire

As part of our aim to keep clients and customers informed of our current investment views and how these themes are impacting our portfolios and funds, Phil Attreed, Head of Wealth Specialists, talks to Will Hobbs, Chief Investment Officer, about recent interest rate rises, the latest on Ukraine, and China's coronavirus (Covid-19) outbreak.

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