5 important questions investors are asking about inflation and interest rates

John: In the wake of the pandemic and Russia’s invasion of Ukraine, there’s certainly a chance that the potential for higher long-term inflation has increased.

This has been driven by a number of things, not least a demand for greater security of resources; we’re already seeing a number of large companies beginning to shift their manufacturing bases back from lower-cost countries such as China and other parts of Asia. As a result of the situation in Ukraine we’ve also seen a desire to increase defence expenditure; this is something that will come out of Government funding and therefore will, by its nature, be more inflationary.

John: I don’t necessarily think we need to create a recession, although central banks might end up doing that.

There are two types of inflation: demand-pull inflation and supply-push inflation; at the moment we’re experiencing a bit of both. The demand side has largely been driven by the countries that were more generous during the pandemic and handed out cash to consumers, creating excess demand. And the supply side has been driven by the effects of Covid and, more recently, the situation in Ukraine, whereby certain goods – in particular commodities – are not available in the amounts they were before.

These things should right themselves over a period of time but it probably won’t happen quickly. In the meantime, central banks are desperate to reserve their inflation-fighting credentials and may well end up tightening policy and pushing major economies into a recession, but a shallow recession, one would think.

John: When people think about higher interest rates, they usually cast their minds back a few years; there’s a lot of talk about the 1970s and double-digit interest rates, for example. We don’t think that is a possibility this time round, given the fact the world is a much more indebted place – not only with regards to consumers and companies, but also governments. This means that if you start pushing up interest rates too high, the cost of servicing those liabilities will become too great and will themselves create a slump in demand.

Currently the expectation in the UK is that interest rates will reach somewhere within the 2-2.5% range before the Bank of England has to stop raising rates. In the US this threshold is somewhat higher, in the region of about 3.5%. But, although we expect rates to remain in the low single digits, this should be enough to induce something of a slowdown.

John: For the last twenty or so years, bonds have been a fantastic diversifier; that has been why we’ve been living in a lower-inflation environment.

Our work has previously shown that if inflation starts to go beyond certain levels – much higher than 3%, for instance – bonds are perhaps, no longer such a good diversifier. That has definitely been the case for the first few months of this year. To that end we started to try to put some different areas of diversification into portfolios, particularly through the alternative asset classes. However, in the last few weeks we’ve seen that, as people have begun to worry more about the growth slowdown and the pace of inflation, bonds’ yields have [fallen] a little bit and they are providing a slightly better diversification tool.

In future we may see bonds being good diversifiers at some points and less good at others. Not being in a long regime, as we have been in for the previous couple of decades, we might also expect that if inflation turns out to be more volatile, then the relationship between bonds and equities might equally become more volatile. If that were to be the case, we would seek other parts of the portfolio in which to diversify risk.

John: There’s no doubt that the direction of moves in the market is defined by the fundamentals. Sometimes, in the short-term, some of these moves get extrapolated a bit too far – what we might call ‘the tail wagging the dog.’ This is the effect of technical events going on in the background, as well as fund flows – and as you mention that might include algorithmic-driven funds, or it could be things going on in the options market with certain hedges being put on and taken off, for example. In the end, though, value will out and the market will go to its true level.

At this stage, people may be concerned about portfolios losing value and asking whether they should be getting out. In the short term it is quite possible that we will see further downward shifts in equity markets in particular. However, the key thing is whether or not we see permanent loss of value; we believe that the companies we invest in will still be here in the future to engage in the recovery that comes thereafter.

If you look back at history you will see that markets always come back up to the levels they were previously at, even if it takes a bit of time. Whereas if you're not in the market and the market goes up, you can never recover that lost performance.