In this note we will discuss what happened, why this is happening, what the market impact has been and Luna’s current views.
The Federal Reserve (Fed) increased US interest rates by 0.75% to a range of 1.5% to 1.75%; their biggest interest rate rise in nearly 30 years. The Fed also signalled that borrowing costs could reach 3.4% by the end of the year. This was a slight surprise to markets as most investors had previously been expecting a 0.5% increase in June and July.
Closer to home, the Bank of England increased UK interest rates by 0.25% to 1.25%, the highest since 2009. Six of the nine members of the Bank’s Monetary Policy Committee voted to raise rates to 1.25% but three backed a bigger increase to 1.5%. Looking forward the expectation is that interest rates will continue to move higher over the coming months with Capital Economics speculating that base rates could reach 3%.
During their June meeting, the ECB signalled that they would be looking to increase their interest rates from July. This has seen bond yields rise on the continent. One issue with bond yields moving higher is the extra costs associated on interest payments. We remain in a highly indebted world and small increases in yields have the potential to severely impact highly indebted countries. This triggered the European Central Bank (ECB) to hold an emergency meeting because of the impact higher borrowing cost can have on specific member states.
Why is this happening?
In a word; Inflation. Globally inflation is running at generational highs.
Inflation was high as we entered 2022 due to the surge in demand triggered in the aftermath of Covid. As well as this, global supply chains have not recovered from Covid lockdowns and have struggled to cope with the excess demand. This has led to shortages and delays. Russia’s invasion of Ukraine only accelerated this further with both countries being key producers of essential commodities. Prices of oil, natural gas, wheat etc have all moved higher and increased the inflationary pressures being felt.
To highlight this the UK’s Consumer Price Index (CPI) rate hit 9% last month and during the Bank of England meeting last week they warned it could top 11% this year. This is not just a UK phenomenon though; US CPI is 8.6% and European CPI is 8.1%.
Central banks have a dual mandate to maintain stable prices (inflation) and economic growth. Although many of the price increases in the economy are outside the central banks control, they are keen to keep a lid on rises in wages for fear that levels matching the pace of price increases will only make the inflation problem worse. By raising interest rates and making the cost of borrowing more expensive, central banks aim to reduce the demand side pressure in an economy.
What has been the impact on markets?
Global government bond markets have been hit hardest this year, with prices falling and yields moving higher to reflect the anticipated rise in interest rates. Inflation and interest rates moving higher have made government bonds less attractive to investors. This has impacted other fixed income asset classes like corporate bonds.
Global equity markets have also been under pressure and have moved lower. This is because rising interest rates can weaken economic growth and increase the risk of a recession. This impacts company profitability and means companies are worth less. The S&P 500, the main US equity market, moved into bear market territory, which is a fall of greater than 20% due to the forward looking nature of equity markets.
What are Luna’s current views
2022 has been a difficult year to be invested with both bond and equity market selling off in tandem. As well as this, the high inflation data only continues to impact the real return on investments.
Central banks appear to be caught between a rock and a hard place. They want interest rates to be higher to stem the longer term impact of high inflation becoming embedded but they are restricted in what they can do because of high debt levels and economies that were already slowing due to supply chain issues. Ultimately, central banks will not want to push their economies into recession. At the moment, the Fed can make larger increases because the US economy is strong but that might not be the case as we move through the year. The unknown impact of these interest rates rises is leading markets to become nervous.
Inflation is stubbornly high and it is likely to continue to be in the headlines in the coming months but a lot of the journey has happened. As we move through this year it is possible you will start to see some of these pressures easing and inflation starting to fall. This will take the pressure off central banks.
Investor sentiment is very weak at the moment, and every negative data point, like a US CPI reading or central bank meeting is driving markets in the short term.
We continue to stick to our approach of finding good quality companies. We have a preference for businesses that have pricing power and can pass on higher inflation to customers. We are going through reporting season at the moment and the companies and fund managers that we are speaking to have two key messages; they are slightly cautious on the outlook but are not seeing any impact right now of inflation impacting revenue and profitability.
As ever, if you have any questions please get in touch on 0161 518 3500 or email a member of the team.
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