April brought warmer temperatures to the UK, but for investors, there was stormy weather. Central banks have been grappling with how to bring inflation under control, culminating in the Federal Reserve’s 50 basis point rise in early May, its largest hike since 2000. Higher rates reduce the net present value of future cash flows, dragging down asset prices. Higher rates also increase companies’ debt servicing costs, cutting into margins, and further hitting stock prices. The inflation has come at a bad time for the global economy, as the Covid bounceback has sputtered out. Looking around the world, we can see separate and interlinked inflation drivers.
The Bank of England hiked rates and warned that the UK economy will likely enter a recession this year. It predicts inflation to top out at over 10%, squeezing household finances, and predicts the economy to shrink a second time in 2023 as government spending dries up. The bank’s new rate is 1.0%, its highest since the 2008 crisis. Geography and post-Brexit bureaucracy mean the UK faces constrained supply chains, exacerbating inflation.
Our new UK Infrastructure fund proved its worth in April, as one of the few areas to deliver a positive return. Infrastructure projects typically have revenue linked to CPI, which provides an automatic inflation hedge, and the security of government contracts means they can act like defensive bonds when markets fall.
The Federal Reserve has begun tightening with gusto, raising rates by 0.5% early in May, the largest single hike since 2000. In the US, inflation is driven more by pent-up demand and a tight labour market, combined with supply chain disruption in China. News that the economy shrank in the first quarter came as a shock, but digging below the headline number reveals the fall was largely down to the strong US consumer sucking in imports.
Higher rates have seen the dollar strengthen sharply, bolstered by the greenback’s safe haven status in times of market turmoil. This creates a useful stabilising factor for UK investors; while the S&P 500 is down -12.9% since the start of the year in dollar terms, our Fidelity US index fund was down only -4.3%.
Europe’s inflation is coming less from pent-up demand and more from being at the pincer point of higher oil and higher food prices resulting from Russia’s invasion of Ukraine. The ECB has been slower than other central banks to tighten policy, with the central bank still scarred by premature attempts to raise rates in 2011. Chief Christine Lagarde signalled the bank will begin tightening by year-end. European gas prices dipped but remain up 40% since the start of the year.
Emmanuel Macron won re-election in France, which was positive for markets but largely priced in. Macron’s manifesto included plans to raise the pension age, which should soothe French government bond markets, and his plans for six new nuclear power stations will bolster France’s relative energy independence. One of the largest positions in our Montanaro European fund is Edenred, the French payments company, which rose 7% in April, boosted by Macron’s victory.
It has been an unhappy month in emerging markets. The stronger dollar has reduced EM purchasing power and made dollar-denominated EM debt more expensive to service. Russia’s invasion of Ukraine has caused further chaos. Countries which depend on food and energy imports, like Sri Lanka and Turkey, where inflation has hit 70%, are the worst exposed.
The new “zero Covid” lockdowns in China have knocked confidence in the world’s second-largest economy, and intensified supply chain issues. Chinese stocks are now at their lowest valuations relative to developed markets since 2015. The falls have been painful but point to significant potential upside, which our new China Evolution fund stands to gain on.
Historically, Japan’s Yen has acted as a safe haven during times of market turmoil, which has been a useful feature for sterling investors. However, 2022 has proved an exception, with the Yen down double digits against the dollar year-to-date. Investors are betting that Japan’s sluggish economy will give leeway to the Bank of Japan to keep rates low, and money has flooded over to America now that the Fed has begun tightening.
The global economy faces short-term challenges as the rebound from Covid loses momentum, and inflation forces central banks to hike rates. However, in the longer term, we believe growth will return thanks to the strong financial position of households in developed markets.
Therefore, we remain constructive on stocks and have maintained full exposure, but we have prepared portfolios for higher rates by shortening duration. This involves switching from longer-dated to shorter-dated bonds and from growth stocks to value stocks.
Down markets are painful but are the price investors must pay to earn good long-term returns, and our moves have already helped portfolios weather the storm.