Inflation will soon peak. You need to be ready for what happens next
Inflation and interest rates could soon start falling, and faster than we think. When they do the investment conditions of the last year could swing sharply into reverse. We’re not there yet, but the moment is edging closer. By this time next year inflation and interest rates could be falling as fast as they rose, and investors should get ready for it today. Because soon stock markets bonds, Bitcoin and the rest could all start behaving very differently.
Interest rates will soon peak
Inflation isn’t beaten yet. While US consumer price growth dipped from 6% to 5% in March, it was still 6.9% in the eurozone and a beefy 10.1% in the UK. By the end of this year, the Federal Open Market Committee, European Central Bank and Bank of England all predict it will have fallen below 3%. In 2024, interest rates will continue falling towards zero, which is now the "natural rate" in the developed world, the IMF says, due to our ageing populations and declining productivity. Emerging markets will soon follow us down the same path. We're heading back to the future at speed.
Lower rates meant higher growth
We all remember what happened last time interest rates were almost at zero. Share values rocketed, especially in rapid growth sectors such as US technology, while crypto-currencies such as Bitcoin ran rampant. Global investors embarked on a “hunt for yield”, as bond yields plunged and savings rates fell almost to zero. The fun stopped as inflation hit a 40-year high due to post-Covid supply chain hold-ups, soaring energy prices and years of loose monetary policy. New York’s tech-focused Nasdaq index crashed by a third, while Bitcoin plunged from $67,000 in October 2021 to $16,000, losing three quarters of its value. It was brutal, but now the worst is over. Investors are hanging on for the day when the US Federal Reserve “pivots” and starts slashing interest rates rather than hiking them. They want the good times back. Yet the world won’t be exactly the same as before. It never is.
Worried new world
The US, Europe and UK still face plenty of challenges, warns Vincent Mortier, group chief investment officer at the Amundi Group. "Weak corporate margins, expensive valuations and the potential rebalancing of large pension funds away from stocks make us cautious on developed market equities.” Mr Mortier suggests investors explore “defensive areas with attractive valuations and strong earnings potential”, notably “dividend-paying stocks that boost investor income”.
As with every investment theme these days, there is a wide choice of exchange traded funds (ETFs) to help you play it. The iShares Core High Dividend ETF, which yields 3.9%, and Vanguard International High Dividend ETF, which yields 4.5%, may tempt dividend seekers. The iShares UK Dividend UCITS ETF yields an even more impressive 6.5%. Few expect a quick tech stock resurgence, even when the long-awaited pivot arrives. Amazon, Facebook owner Meta Platforms, Google, Microsoft and Tesla are busy laying off thousands of workers and freezing new hires. Tech valuations are still high and the recovery could take years. Just like it did after the dot.com crash in 2000. Those willing to take a risk on the next generation of tech giants might consider Cathie Wood’s popular ARK Innovation ETF, which specialises in "disruptive innovation” across the biotechnology, automotive, energy, technology and finance sectors.
It crashed 39.17% in the year to 31 March, but far it’s up 29.13% year-to-date. This remains a high-risk option, though, and not for everyone.
Feeling brave? Then try these
Now could prove a rewarding time to embrace riskier assets, with a limited part of your portfolio.
Goldman Sachs Asset Management says small caps historically perform well when inflation has been high and falling. History shows they typically outperform following a recession, which many expect to strike the US later this year. Forward investors could add exposure today while "relative valuations are at or near historical lows,” Goldman Sachs suggests. Those keen to play this theme may consider the US-focused Vanguard Small-Cap ETF or global options Schwab International Small-Cap Equity ETF and iShares MSCI World Small Cap ETF.
Emerging markets could also bounce back when investment sentiment picks up, according to Lazard Asset Management, which notes that they started the year strongly and were relatively unscathed by March’s banking stresses.
Vanguard FTSE Emerging Markets ETF, iShares Core MSCI Emerging Markets and SPDR Portfolio Emerging Markets ETF are all popular funds in this sector. Lazard says Japan could also shine as monetary policy normalises and corporate governance reforms kick in, while valuations look attractive relative both to historic levels and other markets.
MSCI Japan UCITS ETF, SPDR MSCI Japan UCITS ETF and Lyxor Core MSCI Japan are in demand.
Spread your risk
Inflation isn’t beaten yet. Deglobalisation, reshoring supply chains back to developed markets, higher commodity prices and a tighter jobs market could all keep consumer price growth higher for longer.
Jean Boivin, head of the BlackRock Investment Institute, suspects inflation will prove sticky and reckons US Federal Reserve rate cuts this year are unlikely. BlackRock has responded by going “tactically overweight” on inflation-linked bonds, what Mr Boivin now calls “one of our highest conviction views”.
ETFs investing in Treasury inflation-protected securities, or TIPS, may tempt those who share his belief that inflation isn’t beaten.
Vanguard Short-Term Inflation Protected Securities ETF and iShares TIPS Bond ETF are big players here, yielding 4% and 6.12% respectively.
The future is coming. Get ready for it
Making big calls on market movements is always risky. Maintaining a balance, diversified portfolio and investing for the long term is the key to investment success, regardless of whether inflation is falling or rising.
An unexpected shock, such as another banking crisis, could destroy market sentiment in a moment.
Yet investors are starting to look past today’s inflation. There are dangers in buying the recovery before happens, but those who wait until afterwards will have missed it.
Harvey Jones has been a UK financial journalist for more than 30 years, writing regularly for a host of UK titles including The Times, Sunday Times, The Independent and Financial Times. He is currently the personal finance editor of the Daily Express and Sunday Express, and writes regularly for The Observer and Guardian Unlimited, Motley Fool and Reader’s Digest.
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