While the attention of many UK investors has been riveted on the turmoil in sterling and UK government bonds, they should not ignore the global context in which this turmoil has taken place.
Led by the US Federal Reserve, there has been a concerted campaign to raise interest rates in advanced countries as central banks react to spikes in inflation.
They seek to correct the mistakes of 2021 when they persevered with ultra-low rates and lots of additional money creation for too long. From New York to New Zealand and from Brussels to Seoul, official interest rates have risen. This led to massive bond sales, pushing longer-term interest rates up in sympathy with official short rates. I kept the fund away from longer term bonds in anticipation of these moves.
Only China and Japan remained outside of these changes. They brought inflation under control by limiting the expansion of their money supply, by better controlling credit and prices. Japan still borrows money for almost zero interest.
The danger now is that central banks will go from the error of too much money and credit with too low rates (which is inflationary) to too little money and credit with too high rates, causing a recession . Asked about this, the Fed replies that hard medicine is needed to reduce inflation, its only current priority.
This year, the 10-year interest rate on US government debt has risen from 1.65% to a high of 3.94% on September 27. This forced US mortgage rates to rise more than 6% and led to a sharp decline in housing. market.
The European Central Bank was slow to halt bond purchases and raise rates, but German 10-year government borrowing costs rose further, from negative numbers at the start of the year to a recent high of 2.2%. With German inflation above double digits, this still looks weak and means more rate hikes are to come.
Both the Fed and the European Central Bank have made clear their desire to raise rates further, which helped fuel September’s choppy selloff. As a result, the interest rate on very long-term borrowings is often now lower than the interest rate on shorter-term bonds. This reflects the growing market view that we are headed for a sharp downturn in activity that could turn into a recession in some countries.
Once a recession has been long enough and deep enough to convince the central bank that inflation has been killed, it will have to lower official interest rates again.
As we approach the northern winter, markets need to worry about ongoing supply issues in energy markets. The EU has just announced policies to reduce peak electricity demand, cap prices and tax excess profits.
If the winter is cold – with too many windless days – the EU may have to take stricter measures to ration electricity, with more difficulties for industry in general and energy-intensive businesses. energy in particular. The United States is in a strong position with a surplus of gas for its own needs. Surveys point to a slowdown or recession with weaker industrial orders.
This backdrop was also unnecessary for most stock markets. The clear intention of central banks to reduce demand, money and credit in the system means lower revenue growth, lower profit margins and lower profits for many companies. Nor is the market yet able to set a clear and credible timetable for how long central banks will pursue tight policies and when they will have to back down to prevent a downturn from turning into a meltdown.
The portfolio maintained a commitment to equities as a balanced fund should, with an emphasis on a broadly diversified portfolio around the global index. The exit from the Nasdaq, the U.S. technology index, helped control losses, with the global index having some sectors like energy faring better in the tough conditions.
The fund still retains some of its specialist traded index funds offering exposure to the digital revolution and green transition. While the underlying companies’ business in these areas continued to grow, their overall performance suffered as markets discount future revenue and earnings growth at higher discount rates to reflect higher interest rate. Clean energy and battery technology are the strong performers as countries attempt to accelerate the pace of renewable energy investment.
We’ve had such a bond sell-off that I’m starting to commit some of the fund’s cash to 10-year Treasury bills. Global investment markets will not function well until the United States changes its recession-promoting policy. European markets understandably remain nervous about the war in Ukraine and the disruption in energy markets.
As I write this, the market is rallying on hopes of some limits on rate hikes as evidence mounts that inflation will fall next year. Bonds should be the first to improve.
If we are lucky, the Fed will start to relax before triggering a deep recession. Otherwise, the Fed will relax further at a later date. Either way, inflation will be much lower and longer-term interest rates will then fall.
Sir John Redwood is Charles Stanley’s chief global strategist. The FT fund is a fictional portfolio intended to demonstrate how investors can use a wide range of ETFs to gain exposure to global equity markets while reducing investment costs. [email protected]