How rising rates and inflation will affect investment markets

Investment markets are experiencing renewed volatility in recent weeks as a result of rising interest rates as central banks try to control inflation.  In Australia, inflation is at 5.1% (year over year) – a level we havent seen since early 2000’s.  The USA posted 8.6% in June – their highest since the 1980’s.  

To put it in perspective, developed countries like Australia and the USA try to maintain year on year inflation at between 2 and 3%.   

The drivers of this inflation has been blamed on several things: 

1) Demand-pull inflation which is where a lack of supply and therefore increased demand pushes prices higher.  The Covid-lockdowns from 2020 ceated excess demand for products in addition to supply issues because of closed factories – and that has driven inflation higher.  And with consumers in lockdown, they have been able to save a lot of their money, or have been shifting what they have been buying.  We have also seen property prices rise due to this demand – with fewer properties for sale beign fought over by a large number of buyers with FOMO! 

2) Cost-push inflation which is where the rise in prices of production or service inputs like energy costs, transport costs, wage costs etc causes prices to rise

3) Government monetary stimulus (aka money printing) which has flooded the economy with excess cash (in effect driving the demand for products and services higher too).  In the USA, 80% of their current money supply was printed in the last 2 years…. 

All this results in consumable things and services becoming more expensive – everything, from food to luxury goods as well as property.

What is concerning is that this round of inflation is happening while global economic growth is slowing – due to supply line disruptions post-Covid and the impact of the Ukraine-Russia war.   

This has created an economic situation called “Stagflation” – stagnant economy mixed with rising inflation.  

HAVE WE HAD STAGFLATION BEFORE?

The last time we experienced stagflation was in the 1970s when OPEC cut off oil exports to the West because of the USA’s support of Israel in the Yom Kippur War.  

That created a dangerous combination of economic factors. Oil prices skyrocketed 300 percent within a year. Prices on other commodities jumped, too. Employers, responding to the price shocks, cut their workforces, leading to high unemployment. 

The phenomenon baffled policymakers, who had assumed inflation and unemployment had an inverse relationship. They were wrong, and Central Bankers lacked a playbook to address stagflation. The crisis dragged on until Western economies were able to build out their own commodity production capacity to compete with sometimes-adversarial exporting nations.

HOW DO WE GET OVER STAGFLATION?

Avoiding stagflation is difficult, because financial regulators have to balance two competing interests: inflation and unemployment.

Dealing with inflation usually involves hiking interest rates, making it more expensive to borrow money. That depresses consumer demand and makes running a business more expensive. Employers often respond by trimming their workforces, sending unemployment up. 

Conversely, central bankers could try to lower unemployment by cutting interest rates, creating incentive for employers to make large investments, hire and take market risks. But when employers hire, wages rise. And when wages rise, consumer prices go up (i.e.: inflation). So regulators are mostly stuck when it comes to stagflation.

The conventional wisdom on solving stagflation is to deal with inflation by raising rates and sacrificing economic growth and higher unemployment. The rationale is that the market recovers faster from unemployment than it does from persistently high consumer prices.

The only known remedy for stagflation is to trigger a recession. Central Banks would have to cause unemployment to go up; it would have to cause a recession to convince the public it is serious about the 2 percent objective, and that they need to reset their expectations, their wage demands, their pricing behavior so it is consistent with that 2 percent.

In other words, the goal is to turn a stagflationary market into a recessionary market, and recessions typically resolve in a little less than a year.

In developed markets like Australia, the United States, the euro zone and Japan, that will mean some hard times for consumers and periods where hundreds of thousands of people probably will lose their jobs. But on the other side of the recession, wages will be higher — wage growth that tracks with inflation generally persists after inflation cools — and investment markets will stabilize and employers will staff up again.

All that said, a major driver of stagflation is high commodity prices — things like oil, wheat, steel and other foundational market items. As commodity prices rise, everything else in the economy becomes more expensive, too. One way to tame those prices is deregulating those industries, but it can take months or years for those effects to reach a producer’s bottom line. 

The real long-term risk is in emerging and developing economies, such as Brazil, Russia, India, China and South Africa. They are all major exporters whose markets rely on importing countries to sustain growth. If the economy contracts — especially the Western consumer economy — developing countries will have fewer places to send their stuff.

Those economies are also heavily dependent upon foreign investment, but if international markets are turbulent, businesses are likely to pull back from developing countries whose economies are more risk-prone. That could lead to credit crises in developing market nations that could hamper the global financial recovery.

SO WHAT SHOULD INVESTORS DO?

We believe investors should brace themselves for a lot of volatility over the next 1-2 years. 

At best, you can expect a period of lean or even no growth to your investment portfolio while the economic situation plays out.   

It will likely get worse before it gets better.  The problem is no one knows for sure  how bad it will get – or what the contagion effect is going to be – or how long it will last…

So as a general strategy, it’s probably a good time for investors is to consider de-risking their portfolios.   We aren’t suggesting to sell everything and go to cash – but rather to reduce exposures to those assets that are likely to underperform:

1) Change to a more conservative asset allocation

This means reducing your exposure to growth assets and moving a larger percentage of your portfolio to cash and fixed interest products like bonds.    

2) Switch to defensive sectors for growth assets.

For your share investments, consider switching out of cyclicals and into defensive sectors such as consumer staples, utilities and healthcare

Please get in touch with me HERE to discuss your individual portfolio strategy – as we need to consider things that will impact your own situation – such as your financial situation, your goals, income requirements, how you are invested, capital gains tax etc

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Zac Zacharia (Managing Director) has been assisting clients to create wealth and secure their futures for over 14 years.

He is also an accomplished presenter and educator

Co-authoring the popular investment book, Property vs Shares.