We find ourselves in troubling times. Economically, inflation rages around the globe. Politically, the UK government is resigning en masse. The earnings outlook for companies is challenging. What kind of signs do we need to look for in order to say, ‘It’s time to jump back in’?
It’s a prohibitive economic environment we find ourselves in this summer: at least a handful of developed markets are heading for recession, and the innovative tech industry has once again broken ground: this time by being the first sector out of the gate with layoffs and hiring freezes. We are moving through this economic cycle at an unusually fast pace. The bull market of 2021 got a little bit ahead of itself, and as such, a reset seems to be underway.
The key risk at the moment is not valuations, which have retreated. More challenging will be company earnings, which will have to contend not only with sky-high inflation but, in many cases, with being compared against their 2021 peaks. Businesses will struggle to recreate those successes. In a way, the standard they are measured against has changed.
“Investing, at its heart, is a very optimistic thing to do. You need to believe the future is going to be better than the past.”
Phil Smeaton, Chief Investment Officer
The instinct to examine monetary policy in order to assess what’s coming is a good one, but perhaps not in the way most investors expect. It may be the early days of the tightening cycle, but things are progressing quickly. Before long we will see the Federal Reserve pivot; perhaps even this year or next, everybody’s favourite central bank could well switch from raising rates to razing them (or at least knocking them back a few basis points). But history has shown that the market can be slow to react to looser monetary policy; it would be reckless to buy in on the assumption that lower rates mean the market has bottomed.
More telling in times of trouble is the jobs cycle. It’s inevitable in a recession that a number of businesses will fold. And the people that work for them, most likely after a period of unemployment, will get reallocated to companies whose offerings are more productive for society.
Unemployment is a lagging indicator, but we can keep an eye on companies that are restructuring (often this involves layoffs) in a way that will make them more valuable to society. They need to focus on cash generation and make adjustments that will lead to stronger balance sheets. They have to make products people need. Once these adjustments have been made at an industry level, companies will begin to rehire. It is likely then that the market will recalibrate, giving investors the chance to re-evaluate what’s worth buying into.
Investment View: Has fixed income fallen from grace?
Bonds have been dogged by stubbornly low prices for months. High inflation has rendered them less attractive investments. But enduring some short-term pain now could lead to higher returns in the future.
Simplistically put, inflation erodes your purchasing power. So if you’ve lent money to a government or company (via purchasing a bond) for 10 years, that initial investment is going to be ravaged by 10 years’ worth of price rises. Doing so in a time of record-setting high inflation, like the moment we exist in now, means your money might not be worth very much when you eventually get it back. Put another way, if you lend £100 to someone and you get £100 back 10 years in the future, it may only buy half of what it originally could.
So yes, inflation is bad for fixed income, as it can eat away at your eventual returns. But in adversity lies opportunity. Collectively speaking, investors are not very interested in holding fixed income right now. As investors came to realise these heightened levels of inflation are likely to last, they have demanded higher yields to compensate, and consequently bond prices have fallen this year. This means unexpectedly high inflation becomes expected inflation and is priced in by the market. This means that traditionally safe fixed-income securities have suddenly become discount buys—thus creating a better entry point for new buyers.
It’s also an interesting time for those invested in shorter-dated bonds (say, those due to mature in two to five years), as while you’re likely to endure a small erosion of your purchasing power, your return will still be positive when the bonds mature, partially compensating you for inflation. And when the bond is repaid, you’ll be able to reinvest those proceeds at much lower prices, making your future return higher and better equipped to overcome inflation.
Inflation, however, is an unpredictable beast: as recently as February, the Bank of England forecast that CPI would peak at 7.5% in April 2022—today, it is projected to exceed 11% by October. We cannot know with certainty how inflation will evolve over the next decade, but of one thing we are sure: from a consumer-price perspective, we are enduring troubled times, and as such, have already experienced much of the pain. Whether now is a good time to buy largely depends on more accurate outlooks for long-term inflation. But the midst of a crisis is actually a stronger position to find ourselves in. We are much better off being part way through the pain.
The information and opinion contained in this Monthly Commentary should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by Sanlam. Any expressions of opinion are subject to change without notice. Past performance is not a reliable indicator of future results. Investing involves risk and the value of investments, and the income from them, may fall as well as rise and is not guaranteed. Investors may not get back the original amount invested.