Whilst certain commentators have sought to draw comparisons with the 1970s, in reality the landscape is very different today.
The roots of the current crisis are found in the Central Banks’ response to the Global Financial Crisis of 2008 which saw interest rates cut to below 0% in some cases, accompanied by extraordinary amounts of liquidity being pumped into markets through a process of Quantitative Easing. Fast forward to the COVID pandemic in 2020 and Central Banks were forced to reverse some of the meagre attempts they had made to normalise monetary policy as, to no one’s surprise, they struggled to remove what were intended as only temporary measures. This experimental policy of stimulating the $85 trillion global economy with accumulated debts of a staggering $225 trillion to encourage activity and consumption outwardly worked in an environment where inflation remained very low. However, the reopening of much of the global economy in November 2020 saw inflation pick up sharply, as sudden demand for anything from semi-conductors to lumber from depleted inventories outstripped supply, as stuttering factories struggled in a post-pandemic world.
Perhaps not unreasonably, Central Banks were cautious to act believing that once supply and demand began to come in line, rising inflation may prove to be only transitory. However, Russia's invasion of Ukraine served to accelerate already soaring energy and commodity prices from these two swing producers resulting in inflation spiralling to previously unimaginable levels. All of this has been further aggravated by the ongoing lockdowns in China adding to global supply-chain woes and increasing bottlenecks.
Whilst the EU continues with its negative interest rate policy in spite of inflation raging at over 8%, UK and US Central Banks have sought to catch up with events by raising rates sharply which brings us to the falls seen this quarter in both equities and bonds, the cause of which has been largely mathematical. In spite of numerous bellwether companies reporting strong earnings, 10 year government bond yields, that form the basis from which valuations are derived, have broadly doubled over the last year. This effective increase in the discount rate serves to reduce the Price Earnings ratio and, in turn, share prices where some of the highest quality companies have been hit the hardest. Clearly, Central Banks are mandated to do something in the face of soaring inflation though it is hard to see how raising interest rates helps the cost of living crisis. Neither will such increases lessen the Russian-induced surge in energy and commodity prices. In this regard, energy alone accounts for around a third of overall western inflation, according to estimates by The Economist.
It is notable that the UK market is dominated by highly cyclical energy, mining and banking stocks which account for around a third of the total and is one of the reasons that this index has lagged many overseas indices. To demonstrate the dominating effect of this position in the current environment, according to FactSet, in capital terms the performance of the FTSE 100 Index over the last six months is -3.16% whilst the FTSE 100 Equally Weighted Index - which removes this domination - has fallen substantially more with a return of -18.32% over the period.
Markets were probably too optimistic coming out of the pandemic in an environment of persistently low interest rates and similarly, are probably too pessimistic today as growth slows and financial conditions tighten, albeit cushioned by robust consumer deposits coupled with a strong employment market. All of this suggests that an awful lot of damage may already be priced in, albeit markets are likely to be volatile over the months ahead. Moreover, one should be mindful that equity markets tend to bottom out well before relevant economic data given that markets are, by their nature, forward-looking.
The value of securities and their income can fall as well as rise. Past performance should not be seen as an indication of future results. All views expressed are those of the author and should not be considered a recommendation or solicitation to buy or sell any products or securities.