Pandemic-induced inflation coupled with war in Europe leaves little question: an economic slowdown looms

11 April 2022

Inflation can’t stop climbing; energy prices are through the non- solar-panelled roof; even sovereign bond prices are lying low. There’s no doubt that things look bad. Let’s dig a little deeper into the causes of the slowdown and the nerves pervading markets.

First, the facts: there is a high probability of a recession in the coming quarters. Inflation was already squeezing consumers, and war in Ukraine has only exacerbated this, particularly given the commodities and agricultural products that part of the world produces. But as ever, there are businesses that can withstand this trifecta of economic complexities (war, inflation and tightening cycles taking off). Investors now more than ever need to take a wide view and concentrate on companies that stand the best chance of emerging from this unusual environment intact.

Consider commodities. Energy prices were already ascending given the Covid hangover on supply chains. Policymakers in the US and UK had moved to alleviate energy-price pressure on households even before Russia invaded Ukraine. But in the month since the attack, metals markets have gone mad.

The price of nickel doubled in day, causing such chaos that the London Metal Exchange halted trading. Copper, a bit of a bellwether for the global economy, has had a month of ups and downs. Wheat futures are exploding. The crude oil price is well north of US$100 a barrel. The last time it hit this level was in 2014—and by January ‘15, it had plummeted to US$45/barrel. This is because high prices incentivise production. That production leads to a supply glut, which ultimately leads to lower prices.

So how do we translate this into an investment plan? Where there is volatility there is opportunity. It’s impossible to predict how short-term sentiment will shift, and any plan to sell after declines lock in losses and ensures any recovery is missed. But if you can identify companies that will cope with this transitionary environment and allocate a portion of the portfolio to buy strong businesses on weakness, then short-term volatility can be turned to your advantage without risking your longer-term goals.

“You don’t necessarily lose money on bonds when the price falls; if you hold that bond to maturity, you’re going to get the exact same return you were initially promised” (Phillip Smeaton, Chief Investment Officer). 

Investment view: can we no longer depend on traditional safe havens?

Such is the current state of the world that even fixed income has had its reputation tarnished. Bonds are eschewing their usual behaviour in this unusual environment, but we remain confident that patience will lead to prosperity.

In times like this, low-risk assets tend to reign supreme; but a month into the Ukraine crisis and a year on from the rapid ascent of inflation rates, government bonds have yet to assume the role they normally play in periods of stress. Economic concerns generally inspire flights to safety; but this time around, sovereign bonds continue to taxi.

When you buy a bond you become a lender, and the issuer of that bond is indebted to you. Buying a bond is akin to making an agreement to get certain interest payments. For a cautious investor, watching bond prices fall as inflation marches skyward is disconcerting, to say the least. In the chaos of the current climate (both financial and geopolitical) it’s easy to lose track of the truth.

But the fact remains: when the value of your bonds fall you don’t actually lose any money unless you sell. As we often remind our clients, investing is a long game; while it can feel like a loss due to evident price falls, keep in mind that you can hold that bond to maturity. If you do this, you will get the exact same return you were promised when you bought it. Don’t panic and don’t sell; while your return may be delayed, it won’t be diminished. Your coupon payments will remain the same; you’re going to get your principal investment (in other words, the money you lent the issuer when you initially purchased the bond) back in the end.

It’s true things look less than rosy on paper. As illustrated in the chart opposite, fixed income returns have floundered since the start of the year, and it can be fairly assumed that the economic climate is going to remain challenging.

But therein lies the silver lining: as we’ve explained above, you haven’t lost money when bond prices fall. Your bond return, if held to maturity, remains the same with any paper loss compensated by the future return delivered.

Figures for inflation are running amok in the US and the UK, with the latter announcing a 6.2% annualised inflation rate for the month ended 28 February—the highest reading in 30 years. The good news for investors is that as inflation rises, the yield on bonds tends to increase to compensate you. Furthermore, as we’ve already seen with the Bank of England, central banks generally up interest rates to combat higher prices. This enables bond holders to reinvest their returns at higher rates.

Seek out shorter-duration bonds. Lend your money to a sound corporation for three years, and you’re going to get your expected return with the ability to lock in higher returns at the end of the period. Invest in Austria’s 100-year-bond at yields of less than 1%, and a century of inflation will leave you in the red. Choose wisely, practice patience and take heart: traditional ‘safe havens’ remain just that.

Phil Smeaton
Chief Investment Officer

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The value of investments and any income from them can fall and you may get back less than you invested.