Know What You Don’t Know
Despite the ups and downs of financial markets, October didn’t turn out too bad after all. Concerns over inflation and the prospect of interest rates rising sooner than expected didn’t stop a positive outcome for most equity markets. Even bonds weren’t too far off parity over the month.
Something of a trick or treat month that started in the UK with fuel shortages and ended with a G20 summit in Rome and the start of COP26 in Glasgow and hopefully no COP out as far as dealing with climate change is concerned.
Certainly, Facebook had its own Halloween moment, changing its name to Meta at the end of October as its original name became somewhat tainted. The prospect of Chinese property company defaults was never far away, as were Chinese authorities’ desire to interfere with corporate China in the interests of ‘common prosperity’.
The inflation debate raged on with central bankers on both sides of the Atlantic becoming less comfortable about the transient nature of higher inflation rates and more accustomed to higher inflation’s stickiness. Financial markets’ concerns surround what the monetary authorities will do about it. So, bond yields drifted higher and their prices lower as expectations for two to three rate rises in the US and possibly more in the UK, made their impact. Interestingly, yield curves flattened to reflect inflation potentially being more of a problem in the next couple of years rather than a long-term issue.
What do we know?
Future interest rate increases are priced into financial markets to a large extent, but markets are uncertain if there will need to be more to deal with inflation.
UK inflation stands at 3.1% versus the Bank’s target of 2% although it has been below 2% previously and for some time. Inflation is being impacted by supply shortages as economies rebound post the pandemic which may constrain economic growth if the shortages persist.
Energy prices are particularly elevated and are effectively a tax on the economy; consumers have less money at their disposal. There are labour shortages too, especially skilled labour.
With record amounts of debt outstanding, accumulated during the pandemic, negative real rates (interest rates below inflation) are likely to persist to help governments and their central banks inflate some of that debt away.
What do we not know?
How long will higher prices persist? It is possible that in a year’s time, the year-on-year inflation numbers may look more benign. How severe will the northern hemisphere winter be and its impact on energy prices? It is not yet clear how many people will re-enter the workforce, attracted by higher wages. Can companies pass on higher costs to consumers? It might seem so for now but for how long? How much of the supply shortage is down to inventory re-build and what happens when inventories are re-stocked. The semiconductor shortage may be past its peak; let’s wait and see before making any rash or conclusive predictions in portfolios.
All the talk is of how many interest-rate increases there will be to curb inflation after the Bank of England’s hawkishness has become more apparent this autumn. A reversal of the second of two rate reductions in March 2020 would take base rates back up by 0.15% to 0.25%. Not a gamechanger, but what next? From the headlines, you might think that fiscal policy is much less relevant despite the UK budget last week. It is relevant.
Fiscal tightening could be a key element for economic growth as taxes are forecast by the Office of Budget Responsibility (OBR) to rise to a percentage of gross domestic product (GDP) not seen for a few decades. Taxes are going up in the US too.
Source: NS Partners
Tighter monetary and fiscal policy isn’t usually a good recipe for rebounding growth to continue but if you know what you don’t know, you won’t be positioning your portfolios to make binary bets. If you are generally a long-term investor it makes sense to wait until the fog clears as markets look at more short-term phenomenon. One of those has been witnessed in the US earnings announcements in October where a number of companies beat their estimates and gave equity markets a lift towards month-end, especially in the US.
October felt like a volatile month but volatility, as measured by the VIX, actually fell.
Most developed equity markets posted good returns led by the US S&P 500 which rose by over 6% in October. Europe fared well, Asian markets less so. Japan having done well in September gave back those gains. It was good to see the energy transition and clean energy themes bounce strongly from a disappointing few months after a stellar period previously. Good timing too.
In commodities, oil, unsurprisingly, led the way with good returns from most, but not all, industrial metals.
Currencies continued to exhibit low volatility with the exception of the leading cryptocurrency, bitcoin, which had a strong month bettered only by the Ethereum blockchain platform, buoyed by stronger demand.
Bonds generally edged lower, yields higher, with shorter maturities rising the most in yield terms in the US reflecting the belief that a tougher stance on inflation earlier would mean the inflation threat would subside over time. Corporate bond yield spreads edged higher also. UK index-linked gilts bounced back after a poor September although they still offer negative real yields. Conventional gilts fared better than the previous month too.
We are pleased to report that the T. Bailey Dynamic Fund now has a Morningstar five-star ‘Bronze’ rating.