Call us on 01823 353970

2022 And The Rise Of Inflation.

The cause of the downturn in global equity markets is now obvious with the upsurge in inflation and the consequent need to raise interest rates and risk a recession.

In a recent interview former Bank of England Governor Sir Mervyn King observed that today’s inflation was sparked by a misdiagnosis of the problem at the height of the Covid pandemic back in March 2020. Attempts were made to stimulate demand by further Quantitative Easing when the issue was not weak demand but the lack of supply, with disruption in supply of energy and its derivative products like fertilizers and plastics, metals, glass, agricultural commodities like palm oil and essential components like microchips, and even the supply of labour with the great Resignation and an inability for migrant labour to travel.  In effect a lot of money was created very quickly that probably was not needed.

Raising interest rates is therefore now a necessity and whilst this will eventually quell demand it may take a while to become effective because lots of people are quite liquid given the lack of certain types of spending opportunities during the pandemic.

Higher interest rates however will do nothing to correct the continuing supply problems in commodities, semiconductors and just about everything else so it may also take some time and high interest rates for demand to become depressed enough for the supply to exceed it and so start to moderate price inflation. The timing of this however is unknown.  


So, what does inflation do?

Inflation causes an increase in the cost of the ingredients, components and other inputs which constitute companies cost of goods. For example, a company may make things for £4 and sell them for £10, with inflation it may now cost £6 to make the same items which in turn reduces the company’s profit margin if the company does not have the ability to raise its prices.   


How does this effect share prices?

If the cost of supply for companies is higher and they cannot pass on the full cost this reduction in profits will have a direct effect on the share price. Due to higher cost of borrowing, due to interest rate rises any company wishes to grow and expand also has a higher cost of debt.   As the market look at now but also try to forecast the future it means that growth and profit, they predicted a company might have 6 months ago is lower.  The beauty of the markets is that a trigger down the road may change their opinion of the longer term and we then see share prices start to grow again.


So where are the winners over the last 6 months?

With all the major asset classes down there were few winners over the last 6 months.  Even historically safe havens such as Government bonds have been adversely affected in the short term by high inflation.  The one sector that has done very well recently however is energy. In the US, the S&P Energy Index increased 29% in the first half while in the UK, BP shares rose 17% and Shell 34%. Historically the energy sector is very volatile and therefore too much money in these areas could lead to burnt fingers if oil & gas prices were to fall quickly due to lower demand.  

There are also other winners that have been picked by nimble fund managers, one of which is Novo Nordisk which has discovered that a drug it had developed for diabetics was also the world’s first really effective weight loss drug. The potential market for this product, branded Wegovy, is vast and I certainly will be in the queue for this.


What are the alternatives?

In inflationary periods, an acronym which is sometimes used to describe the investment options is TINA — There Is No Alternative. It refers to the concept that equities will be the least poorly performing sector in such conditions because of the ability of at least some companies to continue to grow revenues in real terms and generate real returns on capital above the rate of inflation. As denoted above Bonds with fixed interest coupons will struggle in these conditions and whist property may provide some safety, issues of repossessions if we have a recession and poor liquidity mean this assets class risk profile is much higher than usual.

Even if you accept that in the short term due to the continued high inflation and falling portfolio values that  it may be tempting to sell equities and go into cash to avoid further falls in the equity market, timing will be of the essence in doing this and I think we can safely say you missed the top.  Getting the other side of the trade roughly right will almost certainly mean buying back into equities when economic conditions are at their most bleak. This is a skill which few, if any, possess.  If you re-invest too late you miss all the gain and have therefore have effective locked in your loss.  The other consideration is time spent in cash whilst waiting is hardly a good bolt hole from inflation as the purchasing power of this money is definitely being eroded.  

Whilst these articles are written to explain the current environment and sometimes can be negative in tone, the message is still consistent “It is time in the market, not timing the market” that is key and therefore we will continue to do what we set out to do which is to assemble  portfolios of high-quality funds over the longer term, ignoring the vagaries of the current market with the aim of long term growth.