Market commentary

High inflation mainly reflects previous large increases in global energy and other tradable goods prices. However, not all of the excess inflation can be attributed to global events. Domestic factors, including high levels of employment in many countries and firms taking the opportunity to increase prices have also played a role.

There are rays of hope that inflation may be close to a peak in some economies with inflation falling in the US for July. Some indicative price rises e.g., used cars, appear to be cooling, perhaps as supply chain issues have dissipated. Also, various key commodity prices such as Oil, wheat and corn are off their highs, partly thanks to global downturn fears. As we have mentioned previously, even a levelling off in prices would result in downward pressure on annual inflation rates as previous sharp increases drop out of the calculation.

October’s new energy price cap will see another jump in inflation. In the United Kingdom, the Ofgem energy price cap mechanism means that it takes some time for increases in wholesale gas and electricity prices to be reflected in retail energy prices. Given the operation of the price cap, consumer price inflation is likely to peak later in the United Kingdom than in many other economies and may therefore fall back later.

Taming inflation will require a number of ingredients. Some are outside the Bank of England’s control, e.g., commodity prices stabilising or retreating, supply chains unclogging. What they can influence however is the degree to which consumers and businesses keep spending and hiring staff. It takes a little time for the interest rate rises to take effect but once they do, we would expect economic activity to cool and with it the labour market.

July’s European Central Bank (ECB) meeting saw it deliver its first interest rate hike since 2011 with a 0.5% rise taking the deposit rate to 0.00%  in a bid to spur spending. Previously, the rate was negative.  Inflation worries are clearly evident, with the ECB President, Christine Lagarde citing key factors behind the aggressive action in increasing rates:

• June’s Consumer Prices record of 8.6%, another clear overshoot of the ECB’s forecasts
• strong momentum across nearly all categories mean inflation is likely to keep increasing
• the euro’s weakness and its impact on prices.

These figures are assuming there is not a complete gas squeeze later in the year. There is a very real risk that Russia shuts off supplies, leading to gas rationing and a potentially big fall in Eurozone GDP into 2023. These risks have seen the euro weaken in recent months.

At the latest meeting, the US Federal Reserve opted once again to raise the Federal funds target range by 0.75% to 2.25-2.50%. Although he was careful to leave all options on the table, Fed Chair Jerome Powell signalled in the post-announcement press conference that smaller increment hikes are likely. Markets are predicting there will be another 0.5% increase in September followed by a final 0.25% increase in November, leaving the target range at 3.00-3.25%.

The Fed continues to respond to the high inflationary environment but there was encouraging signs this week that inflation is starting to peak as US CPI inflation hit 8.5% year-on-year in July, largely driven lower by falling gasoline prices. This was down from 9.1% in June. The current tightening cycle has been the most aggressive of this century with the possibility of interest rate rises amounting to 3% this year. With the latest inflation fall there is hope the Fed will end rate rises by year-end.

The relationship between the United States and China has worsened following the visit of US House Speaker, Nancy Pelosi to Taiwan and the subsequent ‘military exercises’ China has undertaken in Taiwanese territorial waters. China continues to claim sovereignty over Taiwan despite political separation from them since the 1950’s. Taiwan wishes to remain independent, and the US has promised to support Taiwan in the event of China making territorial incursions.

From an investment perspective, the risk here is generally viewed as being one of low probability but extremely high impact and potentially much greater than anything that has ensued from Russia’s invasion of Ukraine.

The Chinese economic outlook continues to look uncertain. The lifting of Covid restrictions across the country in June meant there was some year-on-year growth in second quarter GDP, but at 0.4% it was nothing to write home about. Indeed, some Chinese cities have imposed restrictions upon activity once again, meaning bad news globally for both the growth and inflation outlooks. Achieving the Chinese Communist Party’s 2022 growth target of 5.5% looks increasingly difficult, although may still be achieved with the possibility of a large amount of economic stimulus.

Investment markets are forward looking and with continued surprises in the strength of inflation, this has led to the increase in yield in global fixed interest and the corresponding falls in capital values.

In July, with comments from the Fed that we were starting to see the possible beginning of inflation moderating, this has seen yields come down a little and some capital appreciation. We think the prices of fixed interest take into account the future interest rate rise predicted for central banks so it would certainly be possible to see a more favourable period for fixed interest.

We are watching the Global Short Dated Bond fund in particular but so far it has done what we have asked of it. While it is disappointing to see any falls in value, when we compare the fund to the alternative of longer duration bonds, we would have seen far greater falls in value. The fund is now sitting with a much higher yield and we expect this to help recoup, over time, the losses we have seen more recently.

Please speak to your Financial Planner if you want to discuss your portfolio.