May offered no respite to investors. The longer inflation continues, the more uncertain future economic growth becomes. The main fear is that ’stagflation’ will return. Stagflation is where economic activity is lowered due to the policy decisions needed to combat high levels of inflation and was last seen in the UK in the 1970s.
24th June 2022
Gavin Jones See profile
At its meeting last week, the Bank of England Monetary Policy Committee voted by a majority of 6-3 to increase Bank Rate by 0.25 percentage points, to 1.25%. Those members in the minority preferred to increase Bank Rate by 0.5 percentage points, to 1.5% in the face of inflation reaching 11% this year. But rates remain low by historic standards and the expectation is still for inflation to come back towards the 2% target in the next few years.
UK Gross Domestic Product (GDP) – a measure of economic activity in the UK, was weaker than expected in April, and expectations are now for GDP to fall by 0.3% in the second quarter. This was weaker than anticipated and added to the stock market woes last week. Economists had been expecting a slight increase of 0.1%. Markets are already starting to price in the additional risks of this economic unrest and the potential of recession and that will be part of the stock market falls we have seen in the last few months.
Inflation and interest rates also dominated the headlines in Europe last week. The European Central Banks (ECB) signalled it was likely to raise rates by half a percentage point in September, in addition to a planned quarter-point rise in July. ECB president Christine Lagarde and chief economist Philip Lane had previously said rate rises of 0.25% were the benchmark for its meetings in July and September.
Euro area inflation jumped to a new record high of 8.1% in May. It’s not that long since economists were predicting that Europe would remain in a permanent state of low inflation or even deflation such as that endured by Japan for the last couple of decades. The bulk of the inflationary pressure, as elsewhere, comes from volatile items, such as Food and Energy.
Inflation in the US accelerated to a new four-decade high in May as the cost of petrol, food and other necessities surged. The headline CPI rose to 8.6% from a year ago, faster than April’s year-on-year increase of 8.3% and the highest level since December 1981. The increase was driven by a surge in prices for gasoline, food and shelter.
The Federal Reserve increased its interest rate by a further 0.75% to a range of 1.5% to 1.75%, an aggressive move which surprised markets. US Treasury prices are still expecting another 1.75% of additional Federal Reserve rate hikes by September, with at least one more 0.75% move. This is a significant and fast tightening and has caused the US dollar to strengthen significantly in currency markets.
Emerging Market indices remain largely driven by the fate of China. China’s citizens have been subjected to some of the most draconian social restrictions witnessed anywhere as a result of the Covid pandemic. An under-vaccinated population is deemed by the Government to be at high risk of serious ill health from the Omicron variant that has been brushed off by most of the rest of the world as being of low risk to people.
The latest lockdown has seen economic activity severely curtailed. The Government appears to be standing by its aspiration of achieving 5.5% growth this year, which is igniting hopes that it will unleash aggressive stimulus to meet that goal. However, it is not clear how this might sit with President Xi’s desire to quell the excesses associated with speculative investment in stocks and houses. Chinese stock markets have been under pressure recently as the Government has cracked down on property developers with very high levels of borrowing, such as the troubled Evergrande, and high profile figures in the tech space such as Jack Ma of Alibaba who virtually disappeared at the end of last year.
Central bankers are keen to be seen dealing with Inflation. In recent weeks, we have seen 0.50% interest rate increases in Australia, Canada, and New Zealand and a 0.75% increase in the USA. Even the European Central Bank, which has been sitting at negative interest rates since 2014, is plotting its first interest rate hike in 11 years in the coming months.
The global fixed income market, as measured by the Barclays Global Aggregate Index, suffered its worst ever start to a year since the inception of the index in 1990, delivering a total return of -12.4% at the low point. This is the effect that rising fears of inflation can have on bonds.
As we have stated before the short dated high quality bonds we largely hold have not seen falls that steep, with the Dimensional Global Short Dated Bond seeing falls of just under 7%. The high quality aspect has also helped to protect value as lower quality credit markets – corporate bonds and high yield bonds have fallen further in anticipation of economic weakness as defaults on interest payments from those issuing companies tend to increase when corporate conditions worsen.