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As we leave the summer behind and enter Autumn, those last 3 months carry echoes of 2022, providing investors with something of a reality check following the more positive first-half of 2023.
Unlike 2022, this quarter should be viewed against a background of weakening economic data and falling inflation rates. US Equities fell ~5% in dollar terms but UK investors were protected from much of that by a much weaker £ (those dollar investments convert to more pounds). UK equities hovered in positive territory over the quarter but as I write have fallen back through the first week of October by around 3%. So-called ‘safe’ bonds sold off yet again by up to 6%, while the oil price (the latest suspect in the inflation inquiry) has plunged $5 per barrel. At first sight these moves may seem chaotic, but they reflect short-term, transient events.
In the US, fuel prices shot up 30% over the last quarter, and so demand has plummeted. Depressed demand puts downward pressure on oil prices. This has been exacerbated by horrendous weather and flooding in the North-Eastern states during September. Consequently, fuel which would have found its way to the pumps has instead remained stockpiled, and reserves are now 30 times higher than expected. Americans’ quarterly spending on gasoline is the lowest since the start of this century.
Meanwhile (and more significantly) the seemingly inexorable rise in bond yields – and the resulting negative impact on your portfolio valuation - reflects more subtle interplay. We’ve been talking to advisers and their clients all year about inflation, and by association the likely target-level for interest rates that central banks like the Bank of England and the US Federal Reserve are considering to control it. This matters as much to investors as savers; interest rates effectively determine the relative attractiveness of all financial assets. The yield paid on company shares (equities) is the dividend divided by the price. If the price falls, and the dividend stays the same, the yield rises. The income payments provided by shares, and the yield on interest received for lending to governments and companies (bonds) are both compared to the return for taking no nominal (ie ex-inflation) risk – cash on deposit.
The aim of central banks is to peg inflation at a level that is normally associated with a healthy and steadily growing economy. The target is 2%, yet the current annualised rate in the US is rising again, to 3.7%. However, the basket of goods used to measure inflation includes goods and services that have very volatile prices – we’ve already mentioned fuel, but they also include less vital items like theatre tickets, travel and hotel costs (the Beyoncé and Taylor Swift tours have something to answer for). When a “good” number 12 months ago drops out of the calculation and a (temporary) ‘bad’ month last month replaces it, that can give a false impression of the real direction of inflation. What matters is now and hereafter – August inflation in the UK was 0.4%, equivalent to less than 5% a year, and forecast to be less than 4% when September’s numbers are published later this month.
Remember, when interest rates go up, bond prices go down. With higher interest rates, newly issued bonds yield more than “old” bonds, so the prices of those old bonds go down until the yields are the same. The bond market has already decided Chair Powell intends to keep interest rates ‘higher for longer’, and bond yields are responding accordingly.
We regularly remind our readers that investment requires a focus on the long view. Interest-rate hiking cycles have historically taken 12-24 months to have a real and lasting effect, and we’re 18 months into that cycle; it’s pretty clear to me the forward inflation rate is plummeting, and the fear is of the authorities ‘overdoing it’ on the interest rate front.
Unfortunately, the US Federal Reserve Chair Jerome Powell seems not to have a plan other than to react to the latest data - rather like driving a car while only paying attention to the road 5 yards in front of you.
In the short-term this must be depressing investors’ risk tolerance and indeed their patience. However, I must repeat that investment is a marathon not a sprint. Remember also that bonds (especially government issues) promise a capital return at maturity. A bond that returns £100 in a few years is not going to remain priced at £50 or less for long. Developed nations’ bonds now more or less guarantee a reasonable income without capital loss, if they’re held to maturity. The greatest risk is to the downside in terms of yields, which is great for investors hoping to sell for a profit. Previous extreme experiences suggest that a big fall in yields is more likely than a steep rise in the future, and that would make bonds immensely attractive.
See you next month...
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