As you will no doubt be aware we are currently experiencing an increased level of volatility in global financial markets, and particularly in the UK following the Chancellor’s recent mini budget. We are clearly facing a number of challenges. Inflation has exceeded the levels at which central banks are targeted to maintain not just in the UK but across much of the world and central banks are now raising interest rates accordingly.
Central banks increasing interest rates to curb inflation is nothing new and perfectly normal in a well functioning economy. What has rattled investors this time however is the pace and severity of the rate increases. Initially central banks were of the view that the pickup in inflation was a transitory occurrence which would soon settle back leaving inflation around their target levels, typically 2%. This was not the case however, greatly exacerbated by the war in Ukraine and the energy crisis, inflation became rampant and entrenched, with the US seeing prices now increasing at 8.3% year on year and in the UK the year on year to August came in at 9.9%.
The US Federal Reserve has been aggressive in its response, increasing its target interest rate over recent meetings latterly in increments of 0.75%. The European Central banks similarly began increasing rates far more aggressively than had been generally anticipated.
For the UK the picture is further complicated by the recent moves from the chancellor. Effectively on the one hand the government has just added stimulus to the economy by reducing taxation and providing an energy price cap, whilst at the same time the Bank of England is tasked with reining in prices. At their recent meeting we saw an increase to base rate of 0.5%, historically this would have been considered a significant hike in rates, in today’s climate however, it was deemed by markets as too little. This was seen immediately in the currency markets sending the pound to an all time low against the dollar.
What does this mean for investors?
A weaker pound is not ideal, but it is worth noting that the impact on portfolios will depend greatly on the underling investments. Where we are invested in UK companies, those with significant import costs in their production run will clearly suffer from higher costs, on the other hand, those companies which receive a large proportion of their revenue stream from overseas sales will benefit.
It is also worth remembering that our portfolios invest globally in a diversified range of equities, bonds and alternative assets, all of which behave differently. For investment in overseas funds and companies which are typically not currency hedged, a fall in sterling will translate into a gain for these holdings when they are valued back in sterling. Obviously, this works in reverse when the pound gains against these currencies.
Investments in corporate and government bonds have looked less attractive in recent times, as the prospects of rising interest rates has sent yields higher and prices lower, rendering them a drag on portfolios. At current levels however, they are once again beginning to look more attractive and as and when interest rates peak, will be a valuable inclusion in a broader portfolio.
In summary, inflation and higher interest rates will impact underlying portfolio holdings in different ways. Attempting to make radical changes to portfolios to capture short term movements requires a level of timing and foresight that is not consistently achievable and exposes portfolios to greater risk by being too overweight or underweight in an asset class or region at exactly the wrong time and is therefore not something in which we would wish to indulge. Our recommendation therefore is to maintain a well diversified portfolio with a sensible medium to long term view, and not attempt to react to short term noise.
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