What is happening in markets?

It’s been a punishing year for investors. Global share prices are down by around a fifth while bonds, normally relied upon to play defence, have also fallen. Investors have had few places to hide over the last six months or so, making this one of the most unusual periods in recent market history.

Given how uncertain the current period is, those who claim to know what to do should be treated with a degree of scepticism. As famous stock market investor, Peter Lynch once said, ‘nobody can predict interest rates, the future direction of the economy or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening.’ Forecasting is even harder with the situation in Ukraine.

A well-diversified portfolio and proper financial plan are imperative at times like this. Investing in a range of assets allows you to benefit from different market outcomes, instead of betting the house all on red. A financial plan commits you to a long-term goal, instead of pulling out of the markets and losing ground to inflation, which hit 9.4% in the UK in the year to the end of June.[1]

If you do want the ins and outs of what’s going on though, and the inside track on inflation, read on for more…

Inflation returns

Let’s start with the reasons for this year’s market performance. There are a range of reasons, but the overwhelming issue is inflation. We’ve all experienced it, whether it’s petrol heading towards £2 a litre or a London pint now setting you back by over £6.

The reasons for higher inflation are complex, but our problem is broadly that we haven’t been able to produce enough stuff (a lack of supply, as with oil) or had too much demand, with people having built up savings during lockdowns.  

Should investors be concerned?

While inflation has been elevated for some time, investors only really started to pay attention this year. Many believed that the surge in inflation would be ‘transitory.’ The initial rise was driven by things like used car prices, with fewer cars for people to buy after car factories had shut during the first lockdowns and rental companies having scrapped their fleets to raise cash. Once the pandemic faded away, used car prices were supposed to moderate, along with prices elsewhere in the economy.

Instead, the global economy has been hit by a series of problems, such as Russia’s invasion of Ukraine or Chinese lockdowns affecting global manufacturing. Inflation is now showing up in ‘sticky’ prices, i.e., where prices tend to rise more slowly than across the rest of the economy. What central banks like the Bank of England or Federal Reserve really fear though, is workers demanding higher wages and fuelling inflation further, leading to a vicious circle. 

As a result, central banks are now channeling their inner Paul Volcker, perhaps the most famous banker of all time. At six foot seven, Volcker was quite literally a giant of central banking, and is credited with ending America’s inflation nightmare. Volcker raised interest rates to 20% at their peak, causing a downturn but ultimately restoring the US economy to full health.

Volcker in cigar-puffing prime

What happens now?

Central banks are already acting, with the Bank of England increasing interest rates from 0.25% at the start of the year to 1.75% today. Across the UK, US and Europe, interest rates may have to rise quickly to put a lid on inflation.

Higher interest rates work by squeezing the economy. By restraining demand, central bankers hope to give the economy time to adapt and plug some of the shortages. A sudden rise in interest rates can be negative for shares and bonds. Both are valued on the basis of what they will pay you in future – shares in terms of company profits and bonds as interest on a loan. If you can suddenly get more in interest from your bank, then the value of your shares or bonds will fall to adjust to the new yield.[2]

Can inflation be tamed?

Whether central banks succeed in their Volcker tribute act remains to be seen. Fortunately, there are reasons to be optimistic. Commodity prices might fall back or at least stop rising, for example, particularly if China’s economy slows. The rising cost of living could draw more people back into the workforce, easing pressure on employers to offer higher wages.

If you are tempted to sell…

While it can be tempting to sell at a time like this, research shows that time in the market beats timing the market. Buying and selling your investments can mean you lock in losses and are forced to buy back at higher prices, guaranteeing poor performance.

Sitting in cash is not risk-free either, with cash exposed to the inflation risk. Take the following into account:

·         At 9% inflation, you lose £9,000 in purchasing power on £100,000 in the bank every year

·         The real value of money almost halves if inflation averages 3% p.a. over twenty years

Investing in asset classes like shares can actually help to protect you from the ravages of inflation over the long term, as companies raise their prices over time to offset higher costs or earn larger profits. As long as you are invested sensibly, your portfolio should continue to do well over time.

Chart 1: the impact of inflation

Source: Quilter Investors as of 31 December 2021.

Indeed, you can view the current market as a sale opportunity, with lower values representing a chance to buy more units at a lower price. Investors can use market dips to ‘average down’ the cost of their investments, giving them more exposure to the ‘up-side’.

Imagine, for example, you have £1000 of shares, which fall by 20%. If you buy £200 worth of shares at the low, and your investments then recover to their previous high, you will have a portfolio worth £1250, rather than the £1,200 you put in.[3]

Historically speaking, markets are up the majority of the time, meaning an investor’s opportunity to buy assets at a discount is limited. That also means it’s important not to over-react when markets drop, especially as these falls are a normal part of investing, much like catching a cold is a normal part of life.

If you want a more specific update on your portfolio, we can always provide you with more information.

Please remember that your investments may go down as well as up and you may get back less than you originally invested.

[1] £1000 (initial investment) plus £200 (second investment). The initial £1,000 drops by 20% to £800, before going back up by 25% to £1,000. The second investment rises by 25%, or £50, meaning your total portfolio is worth £1,250.

[2] Lots of factors affect market behaviour, so bear in mind that general principles do not always apply. For example, shares can typically continue to rise during periods of gradual rate rises because the economy is typically doing well and company profits are growing.

[3] Office for National Statistics, July 2022