My dear Friends,

Too many western economies currently sport inflation rates last seen 40 years ago. Central Banks consider measures to bring inflation down. Economists, however, warn this would cause a recession.

The situation is confusing, and the proverbial crystal ball is not the best advice when making long-term financial decisions in difficult times.

So, will our portfolios suffer severe losses while central banks try to save the economy?

Do we need to take steps to prevent central banks from hurting our portfolios?

Missing evidence

There is a general assumption that a rise in interest rates inevitably leads to a slump in stock values and vice versa.

So, why is it then that while the FED did cut interest rates from 2001 to 2003, global stock markets tanked?

Further, between 2004 and 2006, the bull markets continued despite the FED raising interest rates.

There is too little evidence that stock markets actually go down when interest rates go up.

The overall economic outlook determines how economies react to interest rate hikes.

Usually, shortly after an interest-rate hike, stock markets tend to take a downturn only to return to positive within a few months.

Fact Check

Equities can rise or fall whether interest rates go up or down.

Timing and context

Important is the scale and timing of central bank rate changes. Large rate moves over a short period might usually rattle markets. Gradual moves, however, up or down 0.25%, 0.5% or even 1.0%, likely don’t have much long-term effect.

Unexpected moves lead to panic amongst investors and choke lending activity, leading to a slowdown of economic activity and a recession. 

The backdrop of economic, political and sentiment drivers surrounding rate moves is also increasingly important. Central bank monetary policy decisions are important but always part of a broader perspective. 

Mindfulness

Yet, ignoring central bank decisions can also be a bad idea for investors. Prudent investors are mindful of monetary policy decisions, given their potential impact when central banks go wildly astray. 

Today‘s investors need to bear in mind that a vast amount of cheap money flooded markets for a time period of ten years, accelerated by government handouts during the pandemic. This was a historical boost to consumers’ wealth.

So now, there is a risk that this effect falters quickly due to high inflation, falling asset prices and governments unwilling to recapitalize consumers now.

Vladimir Putin’s decision to invade Ukraine only added another shock over a year already defined by a massive economic sea change. We should not forget why inflation rates were rising in the first place, namely, supply chain shortages, too much liquidity, and rising commodity prices.

Clouded by supply-driven inflation pressures, the murky global economic picture is now even more complex and uncertain. And the shifts that turned some of the market’s high-flying winners into losers are only becoming more pronounced. 

A dose of reality

For years historically, low-interest rates and gigantic bond-buying programmes have nurtured a widespread bout of financial euphoria in everything from stocks to digital assets.

“It’s all dreamland that’s been supported by interest rates that aren’t where they should be.” 

Bill Gross, Pimco Investment Group

In November 2021, Christian Sewing, Deutsche Bank’s chief executive, said it is high time for central banks to tighten monetary policy to provide “countermeasures” against surging inflation. 

The question now is if tightening monetary policy to tame financial excesses and inflationary pressures comes with the risk of causing market damage.

Some economists see a 50% chance that a recession is coming. That leaves the other 50% to believe that no recession is coming.

However, while many governments continue to use the printing press to help the war effort extensively and energy prices going through the roof, more and more economists believe we are heading for a recession.

So, high inflation is most likely not a temporary effect as some Central Banks tried to make us believe and clearly, something needs to be done.

Rising interest rates are certainly an appropriate measure. But there is another side to the coin, higher interest rates could send equities on a downward spiral, curb consumer spending, and are a risk for real estate markets.

Most importantly, higher interest rates will hugely impact severely indebted governments.

There is no denying Central Banks have become victims of their own policy and are now captives of the financial markets and indebted governments alike.

Minimizing the pain

Russia‘s war on Ukraine has further added to the inflation problems, but whatever the mode Central Banks will have to raise interest rates.

The war accelerated the price of energy and other commodities and will most likely continue to do so.

European economies will bear the brunt of this development; quite a few are already in a recession due to the pandemic.

The US economy will struggle to absorb rapidly rising energy and commodity costs. As a result, the economy will most likely slow down over the next 12 months.

Africa‘s frail economies will experience a further economic downturn and most likely the worst food shortage in centuries. This could lead to massive social and political unrest in those regions.

Russia‘s declining economy will most likely drag down Central Asia. The already inflation-beaten Latin American economies will have even more difficulty proving their economies’ trustworthiness to investors.

All this will lead to reduced business confidence and higher investor uncertainties and drag down asset prices around the globe.

However, simply selling assets is not the right answer, but reducing excess cash definitely is.

Certainly, some asset classes will lose dramatically at first, only to bounce back to more normal rates in due course. Bear in mind many assets are currently overpriced and need correction anyway.

Falling into panic mode is not a good idea, nor is making short term and emotional decisions. Staying calm and level headed, will be crucial to thinking strategically and long-term.

I know it sounds easier said than done. Believe me, I have my personal ups and downs at the moment. Staying informed, listening to different opinions and chatting with my wealth manager usually takes the emotion out of the equation this helps.

What you can do

Conclusion

Don’t let central bank moves shift you out of equities

Fisher Investments,UK