Thinkpiece

01 Feb Thinkpiece

At times like this, with events seemingly ever more volatile around the world, including our own domestic affairs, I always remember that markets always come through such times.

….but it doesn’t seem like it at the time.

Compounding is hard because a bad month can feel longer than a good decade.

Morgan Housel

Interest Rates

From a financial perspective, what’s spooked markets this year started when Federal Reserve (Fed) Chairman Jerome Powell delivered a hawkish surprise at the press conference of the Fed’s January meeting.

Powell confirmed that the Fed intend to raise interest rates starting in March 2022 and stressed that the path of future rate increases is going to be highly dependent on incoming economic data.

Data that he, you and I don’t know yet. I get a sense he’s telling the market it’s blacker than it may well end up being. We shall see.

Why would the Fed, and other central banks around the globe, want to raise interest rates? Because they use interest rates to control inflation, which has risen sharply in recent weeks.

Inflation

The sharp rise in inflation can be put down to two main causes – Pent up demand caused by covid and ‘working from home’ across the world, where workers were able save money in an unprecedented way. They are now ready to spend. Secondly, and also as a consequence of covid, we have supply chain disruption.

The Fed is not ruling out increasing interest rates more than once a quarter and as a result markets have now moved to price in more than four rate increases this year. If these rate increases don’t come to pass, then this will have been an overaction by markets.

In stock markets, these four conditions are permanent:

Everyday fluctuations

Short-term corrections

Medium-term crashes

Long-term recovery and compounding

The investor who stays the course through these conditions, reaps the rewards.

Impact on Asset Classes

A little bit of inflation (2% for example) isn’t a bad thing for the economy. However, higher levels of inflation are bad news for cash and government bonds. Inflation rapidly erodes the purchasing power of cash, particularly in an environment like today where the interest you get on basic savings accounts sits well below the rate of inflation.

Higher inflation isn’t good news for bonds (fixed interest securities) either. A small increase in interest rates will result in a potentially much larger fall in the capital value of the bond, so as to pay a fixed return to the investor. This is the opposite of what happened to bond values after the financial crisis, when interest rates were reduced to record low levels and bond values rose sharply.

Equities often protect capital in modest inflation environments. Broad-based inflation is, after all, companies demonstrating their pricing power and there is a strong relationship between inflation and corporate earnings.

However, too much inflation is not great for equities either. We’re certainly a long way from that point.

Too little inflation signifies chronically weak demand in the overall economy. Too much inflation is equally troublesome because central banks will generally have to step in and slow the economy down. Invariably, this doesn’t always go well, and the timing may not fit with your financial plan –
The market doesn’t know that you own it!

Sometimes too much in the way of central bank tightening can lead to a period of recession when margins and corporate earnings get squeezed, and equities tend to fall.

Business as usual for markets

..but we must remember that this is all perfectly normal for markets. The 4 most dangerous words in investing are ‘It’s different this time’. It isn’t different next time. Whilst we never know where the next disruption is going to come from, hence holding a diverse portfolio, we do know that disruption is completely normal.

A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.

Warren Buffett

If inflation quickly falls this spring and settles to around 3% in the US and UK, and 2% in the eurozone, then it is not expected to be an inflation backdrop that will trouble stock markets.

How successful investors respond

The answer then for investors, is not to time the market, but to remain in it. Stick with the plan.

If you try and time the market, you have 2 problems – when to come out…..and when to go back in. I have never met anyone that has had sustained success with this strategy.

Stocks don’t go up on time. Stocks go up over a period of time.

The real key to making money in stocks is not to get scared out of them.

Peter Lynch

The answer then is to hold an appropriately diverse portfolio of funds, correctly allocated, and concentrated on quality businesses. Don’t forget the appropriate use of tax wrappers each year either.

This is all part and parcel of working with your financial planner and comes built as standard.

The real measure of financial success

The real measure of success in investing is to consider if your (realistic) financial plan works. If it does, then that’s financial success. This is far more important than whether you’re beating the market.

State Pension

A side point this month concerns the state pension. Usually it’s only possible to fill National Insurance gaps for the previous six tax years but men born after 5 April 1951 and women born after 5 April 1953 have until 5 April 2023 to pay voluntary contributions to make up for gaps between April 2006 and April 2016 if they’re eligible.

We would always recommend people regularly obtain their State Pension forecast and National Insurance record in order to keep tabs on whether they are on track for a full State Pension and, if not, whether they have NI gaps that can be filled if appropriate. These can easily be obtained online and other methods are also available.

Summary

• Stay the course – Don’t try and time the markets.
• Ensure your portfolio is appropriately diversified.
• Volatility is not loss. It’s business as usual for markets.
  
• Remember the key behaviours of successful investors.
• Work in conjunction with your financial planner to construct a robust plan.

Whenever you find yourself on the side of the majority, it is time to pause and reflect.

Mark Twain

The views expressed are not to be taken as financial advice. Professional advice should be sought before proceeding.