Inflation, interest rates to be higher than most investors have seen

Investors will have to navigate high inflation and rising interest rates as well as shifting geopolitics and technology if they hope to maximise portfolio returns over the next three to five years.

Global financial markets are presently hamstrung by levels of inflation last seen in the 1970s, more than four decades ago, and a comparison of the 1970s to the present day is very telling in terms of the outlook from here.

In the 1970s we saw oil price shocks – we have oil price shocks right now; the 1970s were characterised by social unrest and strife, we have that now; and the US Federal Reserve ran a very loose monetary policy for too long during the 1970s, which exactly mirrors what we see today.

It is worth noting that the Fed’s approach to the 2008/9 Global Financial Crisis, and more recently the 2020/21 Covid-19 pandemic, has directly contributed to higher rates of inflation.

The Fed kept rates low for too long while pumping record amounts of cash into the system.

Its balance sheet has gone from $1 trillion to $9 trillion over the last 12 years; that money has fed into the economy and created asset bubbles and excess demand in the system.

The consequence of this central bank largesse is that both inflation and interest rates are going to be higher than they have been during most investors’ lifetimes.

At present interest rates in most countries are way below their levels of consumer price inflation. If central banks want to bring inflation down, they need rates to be much higher – therefore, we expect the US and other developed markets to hike interest rates significantly from current levels, which is going to hit segments of the market hard.

Impact on equities

Investors have already experienced the shock of higher interest rates in the sharp drop in equity market valuations over the past six months.

Global equities are down 20% over the first six months of 2022 while the tech-heavy Nasdaq is down 30%, making it the worst opening half-year for markets since the 1970s.

We talked a lot during 2021 about how expensive stocks were, so we expected them to pull back, particularly technology stocks. What has surprised us though is the pace at which these events have unfolded, which talks to how swiftly global events get transmitted through markets these days.

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The geopolitics theme is best described with the headline ‘the East wins, the West loses’. There is already plenty of evidence of a global power shift from the US to China, from China’s leads in the technology race to its emerging dominance in the space race and the $8 trillion investment in infrastructure projects in its Belt and Road Initiative.

The final theme is of a decade of exponential technology development, and while technology shares have recently suffered a big sell-off there is little sign of the underlying pace of technological investment slowing.

Exponential growth, in both technology and its adoption, remains the backbone of what is happening in the sector. What makes this decade so exciting is that so many emerging technologies are both growing exponentially and converging with each other to accelerate each other’s growth.

This makes for a continuation of startling technology impacts on our daily lives over the coming years.

How to react?

How should investors adapt to a rising inflation? And how can they position their portfolios to take advantage of geopolitics shifts and future exponential technology improvements?

Gold always stands the test of time as an inflation hedge and remains a popular store of value during troubled times.

Other inflation hedges include real assets such as forestry, infrastructure and selected real estate investments alongside inflation-linked bonds.

But it turns out that the China-dominance theme is more difficult to gain exposure to.

It is complicated to invest successfully in a communist-driven economy.

Rather seek out companies that service China and its growth in Asia from countries with more forecastable governments and capitalist models.

As for technology, the recent market sell-off creates opportunities to invest at more sensible valuations.

We continue to be on the lookout for a range of potential investments that will leverage the exponential technology theme, from biotechnology to cloud computing to quantum computing and, of course, the Metaverse.

Hywel George is director of investments at Old Mutual Investment Group.

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