What is happening with inflation?
In the UK, the annual rate of inflation increased to 7% in March, constituting the highest level seen since 1992. The main drivers of this have been higher fuel and food prices, with shelter and used cars also making notable contributions. The war in Ukraine has exacerbated existing supply chain issues which had already come under pressure from strong post-pandemic demand, leading to higher input costs for producers and ultimately, higher prices for consumers. Elevated levels of inflation have a negative impact on purchasing power, that is, every £1 spent tomorrow is able to buy less than it does today.
What is the relationship between inflation and interest rates?
When inflation rises above-target, policymakers raise interest rates in an attempt to slow economic activity. Higher interest rates make borrowing more expensive, which discourages spending by consumers and investment by businesses. Conversely, the return generated on savings accounts and money market investments becomes more attractive, contributing to weaker final demand and an easing of pricing pressures.
What is happening with interest rates?
Policymakers have begun to raise interest rates in an attempt to curb the above-target inflation that is prevalent across most western economies. This year the Bank of England agreed upon its fourth increase in the last six months, taking the benchmark rate of interest to a flat 1.00%. Although visually this may seem like a low number, it represents the highest level seen in the UK since 2009, when the country was battling against the fallout from the global financial crisis. Currently, investors are predicting that rates will need to rise to a peak of 2.5% next year in order to bring inflation under control.
What is the impact on financial markets?
Changes to inflation and interest rates have profound and wide-reaching implications for financial markets with different asset classes being affected in different ways. Most notably, existing investments in bonds become less attractive as the fixed rate of interest they pay could be improved upon elsewhere. This produces an inverse relationship between interest rates and bond prices. Inflation also reduces the real value of the payment received at expiry of the bond, further reducing the attractiveness of the asset class.
As regards the stock market, a greater cost of borrowing reduces the future earnings potential of businesses, which can lead to a reduction in share prices. In particular, companies whose valuations are underpinned by the promise of earnings that grow long into the future are the most sensitive to changes in interest rates. While there are certain industries which can actually benefit from higher interest rates, in general it is considered to be a negative for the stock market.
How can we positon portfolios accordingly?
As a result, a higher inflation and interest rate environment prompts investment managers to think differently about how they position portfolios. At WH Ireland we have made a series of incremental changes over the last 18 months, in accordance with this.
Specifically, we have owned very few bonds compared to history and where there has been exposure, this has been focused around those with the lowest sensitivity to rising interest rates. Likewise within equities, portfolios are now significantly more exposed to sectors that have historically benefitted from rising rates, such as financials and away from those that have not, such as technology.
An exposure to robust dividend payers also allows us to compound this income over time, providing an additional level of protection against inflation.
We have also maintained a meaningful exposure to real assets such as infrastructure, which offer an inherent protection against inflation. Renewable energy companies have been one of the few beneficiaries of the Ukraine war, as they have been able to charge greater prices for the power they produce, while a surge in demand for their assets has provided additional capital returns.
In conclusion, while rising inflation and interest rates can make the landscape more challenging, they also demonstrate the value of an active approach to multi-asset investing. We believe that our portfolios are well positioned and offer protection against both an erosion in purchasing power and permanent losses of capital.