With the media focused on short term political events, the effects of macroeconomic trends can be overlooked. However, it is often these long term trends which drive investment performance. This article looks at the effects and interactions of inflation, growth and interest rates on investment returns.
There are a variety of ways in which these elements can interact. We will consider the investment implications of each in turn.
Investment implications
1. Inflation and growth, which will usually be accompanied by rising interest rates
This is the classical target for governments and central banks. It is characterised by inflation and growth running at a moderate rate with growth increasing by more than inflation; interest rates will rise gently to keep inflation under control.
This situation is positive for real assets. For example, equities will tend to benefit as the increasing amount of wealth in the economy (from economic growth) will lead to increased spending which improves company profits. Non-earning real assets where the supply cannot be easily increased (for example gold) may rise in line with inflation but are likely to underperform earning assets when inflation is lower than growth.
Fixed income assets will tend to underperform in this sort of environment. With interest rates rising, the capital value of bonds is likely to fall. For example, in the UK the yield curve is currently quite flat. If we entered an inflation and growth scenario the yield curve would steepen, with interest rates rising on longer duration bonds. This change in the yield curve would lead to price drops for bonds.
2. Inflation and no growth, which will usually be accompanied by rising interest rates
This scenario is often known as ‘stagflation’ and was widely seen in the 1970s. In this scenario prices are rising (often at an accelerating rate) but growth is small and lower than inflation. Under the Bank of England’s mandate, interest rates should rise in this scenario, although in countries with broader central bank mandates (which make allowance for growth and/or employment) the policy response may be different.
In this scenario, real assets of limited supply will perform best. These are likely to broadly keep pace with inflation as the supply of the asset is fixed.
Equities are unlikely to increase in value significantly as the lack of growth will limit investment, which may negatively impact corporate growth; they may also see price rises from suppliers (due to inflation) whilst being unable to pass them on to customers. Bonds are also likely to perform poorly.
3. No inflation and moderate growth, which will usually be accompanied by declining interest rates
This situation, which has persisted in Japan for over two decades, is characterised by growth at a moderate rate with inflation close to zero. Under an inflation-focused central bank mandate interest rates will remain low in an attempt to promote inflation at a well-managed but meaningful rate. This is the situation which the UK has experienced over the last few years.
Earning real assets, such as equities, will benefit from growth as detailed earlier; the benefit will be even greater as they will not be experiencing price rises from suppliers while seeing increasing numbers of customers. While interest rates continue to decline bonds will also see rises in capital values.
The lack of inflation combined with economic growth will mean that non-earning real assets such as commodities will underperform.
4. No inflation and negative growth, which will usually be accompanied by declining interest rates
This scenario is a classical recession or depression, and the most well-known example of it is the Great Depression of 1930s America. Growth is negative or near zero, as is inflation. Interest rates will be cut drastically under modern central bank mandates to promote inflation and growth.
Long duration bonds are likely to be the best performing assets in this situation. This is due to a combination of falling interest rates and a rush to safe assets leading to rising capital values.
Equities are likely to fall due to a contraction in spending. Assets such as gold (real assets of limited supply) are unlikely to perform well due to lack of inflation. Cash should theoretically hold its value, but it may be that in a severe economic downturn the financial system may be unstable to such an extent that it is risky to hold substantial bank deposits.
Likelihood of Scenarios
We will now consider the current economic situation and which of these scenarios it suggests are likely to happen. Consider the four major developed economic areas: the US, Japan, UK and the Eurozone. All these regions are characterised to varying degrees by low but steadily positive growth, low inflation (and in some places negative) and low interest rates, i.e. scenario 3 above.
The rebasing effect of the oil price drop moving through the inflation figures will lead to a rise in inflation across all countries. Whilst this may increase growth in the US, the UK, Eurozone and Japan are likely to see this causing inflation without creating additional growth.
All countries are likely to see limited effect from continuing current monetary policy. Such easing generally achieves diminishing returns and has already been extensively used. Therefore without innovative measures, such as so-called ‘helicopter money’, monetary policy alone may struggle to stimulate growth. In addition, unwinding monetary easing (whether ending QE programmes or raising interest rates) is likely to reduce growth and inflation. Such tightening is very likely to negatively impact bond markets (and to a lesser extent equity markets) and these market falls may have knock-on effects on consumer confidence, which would reduce spending and further harm growth.
Concerns over monetary tightening are particularly applicable to the US, which appears likely to tighten monetary policy before the rest of the developed world. However, it should be remembered that the US is likely to undertake such tightening because of the strength of its economy, as evidenced by the long term decline in US unemployment.
In the UK, there are unique factors potentially affecting the economy related to Brexit. The weakening of the pound is likely to have the effect of importing inflation. More positively, consumer spending in the UK is growing strongly: if this continues, it should support growth.
Conclusion
Inflation is likely to increase, albeit from a low base. This will be negative for bonds (especially long-term bonds) due to a rise in interest rates; and positive for shares and property.
The more challenging question is whether that inflation will be accompanied by growth. Some factors point towards increasing growth. Improving consumer spending in the UK, low unemployment in the US and reducing (although still relatively high) unemployment in the Eurozone. These point towards expanding spending in the economy, which is key to increasing growth. In addition, a disappointment with savings rates is encouraging people to spend their money, which injects additional spending into the economy and stimulates growth. Equities are also likely to be supported as bonds are unattractive, tending to underperform in an inflationary environment.
On the other hand, tightening monetary policy entails removing money from the economy, which will be likely to reduce spending. Further, if the tightening of monetary policy leads to falls in the stock market, this may impact consumer and business confidence which could cause consumers to save more and businesses to hire fewer people, both of which would reduce the amount of spending further and reduce growth. Avoiding this scenario will rely on the skill of central bankers around the world to successfully unwind the existing monetary stimulus. So far, there are encouraging signs: central bankers seem very concerned that the process of unwinding the stimulus does not damage growth.
It seems likely that central bankers in the UK, Eurozone and Japan will continue to seek ways of stimulating growth. If growth continues steadily then equities and property are likely to be the best performers. Add to this, the improved performance of emerging markets, and it is not hard to imagine a scenario in which the current bull market in equities continues.
Risk warnings
This document has been prepared based on our understanding of current UK law and HM Revenue and Customs practice, both of which may be the subject of change in the future. The opinions expressed herein are those of Cantab Asset Management Ltd and should not be construed as investment advice. Cantab Asset Management Ltd is authorised and regulated by the Financial Conduct Authority. As with all equity-based and bond-based investments, the value and the income therefrom can fall as well as rise and you may not get back all the money that you invested. The value of overseas securities will be influenced by the exchange rate used to convert these to sterling. Investments in stocks and shares should therefore be viewed as a medium to long-term investment. Past performance is not a guide to the future. It is important to note that in selecting ESG investments, a screening out process has taken place which eliminates many investments potentially providing good financial returns. By reducing the universe of possible investments, the investment performance of ESG portfolios might be less than that potentially produced by selecting from the larger unscreened universe.
