We hope you are keeping well as the summer finally draws to a close. Unfortunately, the cooler temperatures have not been mimicked in financial markets since our last correspondence with the news flow really heating up, particularly in the corridors of Westminster; a topic we shall return to later. But of course, the dominant news story of the month was the passing of HRH Queen Elizabeth II. Events that followed stirred great sadness, but also inspired, as the scenes around the country showed the outpouring of love the people had for her majesty. September will surely mark one of the most significant moments in British history, and for the Commonwealth.

Returning to markets and it was also a miserable month for investors, rounding out another difficult quarter and compounding losses already accrued this year. The ongoing challenges of persistently high inflation, hawkish central banks. and anxieties surrounding growth, have proved a toxic mix for investors.

Inflation alone can be punishing to growth prospects as it raises the cost of essential items, such as food and energy, diminishing consumer spending power and crimping corporate margins too. But high and persistent inflation also elicits a hawkish response from central banks to help prevent an inflationary spiral taking hold, where greater demand begets higher prices. This is a material risk in the current regime given the elevated level of wage increases.

Stock markets do not only revolt at higher interest rate/debt servicing costs given the impact it can on growth, however, higher rates tend to weigh on valuations too; as we have seen this year. The relationship is simply a mathematical one, with interest rates the discounting mechanism through which future cash flows are prescribed a value today. The higher interest rates go, the lower the amount investors are typically willing to pay for a business’ future profits.

In order for markets to find a bottom, therefore, investors might first need to see a reversal, or the prospect of a reversal, in each of these forces. Is such a prospect imminent? With commodity prices off their highs, and year over year base effects starting to dampen their contribution to the inflation calculation, such evidence may yet materialise, certainly in the US. What is more, as the pandemic moves further into the past, resolutions to supply chain frictions and a general switch from buying goods to consuming services may place further downward pressure on prices.

China’s ongoing property slump wouldn’t ordinarily be received well by the global economy, however, with inflation the market’s major source of anxiety, a slump in commodity demand and prices could be just the tonic the economy and investors need.

We concede an imminent reappraisal of Central Bank strategy is unlikely given the firm position taken, but a less aggressive approach to policy execution may be all that’s needed to remove investor’s worst fears.

We do not anticipate anything dramatic but, should the employment market start to show signs of cracking and inflationary trends begin to recede, central banks might just soften their language in sympathy.

We also concede there are lots of risk to this view, not least when analysing commodity prices. It would, for example, be pretty heroic to ignore the material threat of higher energy prices as the conflict on Europe’s Eastern flank threatens broader escalation. On balance, however, fading inflationary pressure in the US could yet pave the way for a more forgiving approach to monetary policy in the final months of the year or, perhaps, early next.

Regardless of the path for inflation, equities could be a difficult hold in the months ahead as the market wrestles with the Fed’s determination to tackle it and keep policy ‘restrictive’.

Even if a US recession is a more immediate outcome, an extended downturn needn’t be the base case, however, given the aggregate health of household balance sheets and the absence of corporate excesses compared to previous cycles. It should also be worth noting that valuations are far less demanding than at the turn of the year. We acknowledge valuations are a pretty weak signal in the short-term, but lower valuations represent a better entry point for the long-term investor.

Despite this more positive view, we reiterate the fragility of the global economy. Inflationary risks persist and central bankers’ willingness to defeat it should not be understated. Given such uncertainty, as well as our philosophical recognition of the need for humility when investing, portfolios strive to seek appropriate levels of diversification. Relative to stocks, and whilst far from our ‘preferred’ asset class, government bonds might offer a more defensive return profile in the face of less encouraging growth outcomes, particularly given this year’s move higher in yields. Alternative asset classes also help diversify portfolios in a more challenging period for stock markets.

At this moment we should also comment on domestic events late in September, with the UK government’s (not so) ‘mini-budget’ triggering a dramatic response from markets. In essence, a series of ‘unfunded’ tax cuts designed to stimulate a return to growth, has been received as a stark inflationary threat. In response we saw a dramatic fall in the pound and a sharp ascent in gilt yields, a classic response to international capital flight.

Such was the scale of moves that that the Bank of England felt compelled to intervene in order to prevent a more disorderly fallout within the UK pensions industry where, in their absence, the fall in gilt prices was triggering yet more selling of gilts.

The Bank of England’s response, however, did create some confusion around motives, given the policy’s similarity to Quantitative Easing. To our mind the intervention is both targeted and technical and, based also on the Bank’s firmly hawkish communications, should not be considered the start of debt monetisation (where the Bank of England buys all of the government’s debt issuance).

Depending on the level of unfunded tax cuts, expect a similarly offsetting tightening in monetary policy; action which might arrest sterling’s troubling decline. It is still, however, a very uncertain period ahead for the pound.

Please get in touch if you wish to discuss any part of your investment strategy further.

Kind regards,

iPensions Wealth Team

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