A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK.
When the latest UK official data are published in two weeks’ time it is quite likely that they will show that inflation hit 9.0% in April, the highest level in almost 40 years. The speed and force of the upturn in inflation has been remarkable; just over a year ago UK inflation was running at under 1.0%.
The last 40 years has been a period of steadily declining inflation and interest rates, a transformation that has boosted asset prices and created a golden era for investors. In the US the real return on equities averaged 9.2% a year between December 1981 and December 2021, far outstripping growth in average real earnings of 0.5% a year and overall GDP growth of 2.7%.
Now some investors worry that the age of low inflation and low interest rates is coming to an end. A nasty combination of inflation, lockdowns in China, war in Ukraine and slowing growth has triggered a move away from risky assets since the start of the year.
Global equity markets have fallen over 11% since January. Chinese equities and European stocks have seen larger declines with China suffering from renewed lockdowns and Europe vulnerable to the fallout from the war in Ukraine and disruption to the supply of Russian energy.
The American equity market’s heavy exposure to technology stocks, for many years a source of strength, has hit performance with weakening consumer demand and expectations of higher interest rates taking a toll on tech stocks. Shares in Facebook and Netflix have fallen 44% and 65% respectively this year after announcing declining user or subscriber numbers. Shares in Apple, Google and Amazon have also declined. On Thursday Apple warned that supply chain problems and factory closures in China could cost the business $8bn in the current quarter.
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A classic “risk off” rotation is taking place, with safer, defensive stocks such as utilities and consumer staples outperforming growth-dependent sectors including retail and consumer discretionary. Shares in large cap businesses have outperformed small cap which are generally less resilient and more vulnerable to weakening growth. Emerging market equities have underperformed developed markets. Value stocks, those offering higher dividends, such as oil or commodity businesses, have done better than growth stocks, including in the tech sector, which offer the promise of future gains. In a classic sign of nervousness, the dollar has risen 8.0% this year as investors seek the perceived safety of the world’s reserve currency. Everywhere the focus is on protecting capital, reducing risk and securing income.
This process has created some strange winners, among them UK equities which for more than 10 years have lagged the euro area and US markets. A limited exposure to tech and a significant weighting in oil and commodities has helped the UK market this year, as has the UK’s lower exposure to the effects of the war in Ukraine. UK equities have fallen 3% since January compared to the double-digit losses seen in the main European markets.
In times of uncertainty investors tend to seek safety in government bonds. But rapidly rising inflation, which reduces the income from bonds, has instead caused bonds to sell off. The Bloomberg global aggregate bond index has fallen by over 11% this year, a similar decline to what has been seen in global equity markets.
Inflation is the big enemy of investors and savers. Factor in what appear in many asset markets to be fairly demanding valuations, and the risks are obvious (US equities are trading well above the valuations seen in the last 20 years). The ratio of house prices to incomes are similarly stretched in many markets, with home-buyers dependent on low interest rates to offset the effects of elevated purchase prices (In the US, house prices are up over 34% since the eve of the pandemic).
The hope is that, like previous outbreaks of inflation, in 2008 and 2011, this one will prove short-lived with slower growth, higher interest rates and an easing of supply problems generating sharp falls in inflation through 2023. The worry is that near double digit inflation could convince firms, employees and markets that inflation is here to stay, triggering an upward spiral of wage and price pressures.
The dilemma for investors is that risky assets yield the best returns. With inflation at 7.0%, and bank rates at less than 1.0%, the ultimate ‘safe’ investment, cash, cannot protect the real value of capital. Another option to hedge against inflation is to hold real assets such as gold, commodities, or even fine art or wine. But valuations here tend to be volatile and, with more idiosyncratic assets such as art, transaction costs are high.
Seasoned equity investors might observe that risky assets have come through the shocks and volatility of recent years in good shape and perhaps they will do so again. On some measures US equities have looked overvalued for several years, and that did not prevent further gains. The difference, however, is that inflation is higher today, and interest rates are rising.
Asset values have grown far faster than wages in the last 40 years thanks in large part to a downtrend in inflation and in interest rates. Investors, like central banks, will be hoping that, whatever the short-term risks, the age of low interest rates has further to run.