The Bank of England has raised interest rates from 1.25% to 1.75%, the biggest increase seen in 27 years. Interest rates have risen to their highest level since December 2008 as the UK battles to curb inflation, which is predicted to climb above 13% later this year.
The UK Economic Growth Forecast, also announced by the Bank of England, has warned that the UK is expected to fall into recession, with the economy shrinking in the final three months of the year.
Interest rate rise – inflationary pressure on investment markets
Recession fears and surging inflation is certainly driving market volatility. It has been a tough year for investment markets so far, with factors such as the economic slowdown in China, global supply issues, Russia and Ukraine war, and rising energy prices all contributing to inflation levels not seen for 40 years.
Some comfort to investors is that these issues are now well understood by markets. At the beginning of the year, it was unclear how far inflation would climb and how aggressively and quickly central banks would respond. The unfortunate effect of interest rates rising so quickly is that both equity and bond prices tend to fall and this has certainly played out over the last six months.
In an environment of higher inflation, there has been a rotation towards certain stocks with investors favouring companies that can deliver profits today rather than the promise of profits tomorrow. The FTSE 100 index, which represents the largest 100 companies in the UK, has been a benefactor of this rotation, outperforming other global markets. The reason for this relative outperformance is the FTSE 100 is made up of a large proportion of “old industry” companies – Oil, Energy, Banks, and Mining – which have all performed well.
Long-term investors – don’t panic
Inflation often worries investors, but not all investments are negatively impacted by inflation. In an inflationary environment commodity prices start to increase, which is what we have seen particularly in the Oil and Energy sectors, exacerbated by the conflict in Ukraine. However, as recessionary fears grow and central banks continue to raise interest rates, investors are now more fearful that higher borrowing costs will bring a halt to the expanding economy and demand for commodities will fall.
Whilst interest rate rises are good for cash and deposit holders (it is always prudent to hold some cash in the bank), it is unlikely to benefit from rates that will cover price rises and beat inflation over the long term.
Corporate Bonds and Gilts are generally less volatile than equity investments. The downside to bond investment is that they offer no inflation protection. The interest payments are fixed and their value can be volatile depending on interest rates. This is why the fixed interest sector as a whole has suffered since the start of the year. Having said that, bonds are normally very dependable during a recession and should continue to form part of an investor’s diversified portfolio.
Global Equities have historically offered the best opportunity for delivering real (after inflation) returns over the long term, versus other major asset classes, such as bonds, commodities, and cash. One of the reasons investing in global equities can act as a buffer against the effects of inflation is that there is a positive relationship between company earnings and inflation. Company earnings generally rise as inflation does, as many companies have the ability to increase their prices during inflationary periods to maintain earnings.
Periodic market volatility and market corrections are a normal part of long-term investing and Investment markets have historically gone up over time, just not in a straight line. A well-balanced and diversified portfolio continues to offer inflation protection over the long term.