As we find ourselves almost halfway through the year, the volatility we experienced at the end of 2018 is not only a distant memory but could also prove, with time, to have been the shock markets needed to adjust their expectations in line with reality. Leading up to last year’s market correction, share prices continued to rise and positivity around company earnings growth was unyielding. But something had to give, and when markets took fright there was nervousness that this could be the start of a significant market slowdown.
What that volatility did was to calm markets down to more realistic levels, building in a margin of safety for investors and reflecting the underlying economic reality of a slowing global economy. As with many market reactions, the pendulum swung too far in December and the recovery this year has brought share prices back in line with a reduced level of expected company earnings. This can be seen in the chart below.
There have been signs that global economic growth has been slowing for some months now. Germany is leading weakness in Europe, as industrial production and factory orders are in decline. The US economy is still growing and generating jobs, but growth has weakened from over 4% six months ago to just over 2% today.
We believe this trend is set to continue, and any growth we do see will be driven by productivity improvements and population growth rather than investment. Markets seem to be easing into this new mindset. Perhaps last year’s shock was enough to remind investors that the good times won’t always roll, but that businesses are still making money, and there’s no need to panic. If that continues to be the case, then last year’s pain was worth it in heading off a larger, more significant market shock.
“Markets have rebounded nicely in 2019. Fears that central banks might increase interest rates and push the economy into recession have abated, for now. We will continue to keep a watchful eye on the Federal Reserve’s approach to managing inflation, as this continues to be a significant risk to sustained economic growth.” - Philip Smeaton, Chief Investment Officer
Investment view: Why inflation is keeping us awake at night
There are several reasons why we think it’s prudent to be worried about inflation:
Economic conditions are like those that preceded the inflation shock of the 1980s – very low unemployment and persistently low interest rates and inflation. Back then, sudden wage growth caused inflation to soar from 3% to 10% in less than two years.
The Federal Reserve (Fed) has changed the framework it uses to set interest-rate policy. Historically, they would pre-empt rising inflation by slowly increasing interest rates. The new framework means the Fed will only increase interest rates after inflation visibly manifests itself. This increases the probability that it will rise above 2%, and possibly well beyond that.
Businesses are still able to borrow money at reasonably good rates, which could lead to above-trend economic growth, and therefore inflation.
How can we protect client portfolios?
One way of protecting client portfolios from that risk is investing in government bonds. There are two types of government bond – those that return a fixed level of interest each year, and those that return a (slightly less) fixed level of interest but guarantee your return will increase with inflation. In a high-inflation environment, the latter is favoured as investors seek protection from rising prices.
The chart below shows the level of inflation needed to get the same return on these two types of bond – the breakeven rate. While inflation is not at that rate yet, we have enough conviction in our concerns about it rising to start buying inflation-linked government bonds. Our portfolios also have exposure to infrastructure funds and companies with sought-after products (and therefore the power to increase their prices if necessary), which further protects our clients should our fears be realised.