The UK is in a state of flux, with seemingly endless possibilities about its economic future. On the one hand, the government is keen to stimulate economic growth. Meanwhile, the Bank of England wrestles with inflation, trying to keep prices from spiralling out of control in the wake of an energy crisis.
It appears as though the government has blinked first as it has tempered its plans this week. Chancellor Jeremy Hunt abolished his predecessor’s mini-Budget and has reintroduced tax rises rather than precipitating the cuts previously promised. Yet there is no guarantee that, even with the latest U-turn, the Bank will successfully stymy inflation.
In this new series, Trustnet takes you through the four main possible outcomes: the Bank wins and inflation falls, but at the cost of growth; the government wins with growth higher but inflation is still out of control; a ‘doomsday’ scenario of higher inflation and weak growth; and finally the ‘goldilocks’ option, with inflation down and growth on the rise. Today we cover what happens if inflation remains high while growth wanes.
Rob Morgan, chief analyst at Charles Stanley Direct, said rising inflation “presents significant difficulties for authorities and a nightmare for investors”.
“It could look a bit like an emerging market crisis of the past or a 1970s reboot,” he said.
“Central banks would face the choice of raising rates even more, which would mean a severe recession, or let inflation rip. However, the latter wouldn’t work too well as it would just devalue the currency, which creates its own inflation problems.”
Thankfully, he said this is an unlikely scenario, with the much more likely prospect that inflation will be tamed rather than endure for a long time.
However, it is important to note that even base cases are rarely proved right and it is worth investors considering all potential outcomes and how their portfolios might react accordingly.
In this scenario, risk assets are going to get punished even more and the cost of capital would get higher, with companies hunkering down to avoid the worst of the market wobbles, said Morgan, while those with significant debt would be severely challenged.
“You would want to be holding strong world currencies, potentially the US dollar, and some gold. Perhaps commodity-oriented country currencies would do well if that’s the main source of inflation. It’s a scenario where you have to try and survive rather than invest for high returns,” he added.
Kasim Zafar, chief investment strategist at EQ Investors, said that the proposed environment is not dissimilar to the one we are currently living through.
“Given the blow-out in credit spreads, we think short-dated credit risk looks attractive at this point. We’re avoiding the temptation to buy long-duration government bonds – the situation is still highly uncertain, and it wouldn’t surprise us to see long-dated gilt yields moving 100bps in either direction in a short space of time,” he said.
However, the current difficult situation is not confined to the UK: inflation is rampant in most developed markets, while the global economy is slowing.
“Given the increased probability of a global slowdown, we continue to favour high-quality businesses with less cyclical earnings and strong balance sheets. The challenge is that everyone is investing in these companies to get defensive, so valuation multiples are sky-high in many cases,” he said.
Dzmitry Lipski, head of funds research at interactive investor, said investors should look towards simple-to-understand strategies that focus on capital protection such as the Capital Gearing and Personal Assets Trusts.
Equity investors should take a more balanced approach, while those who are searching for buying opportunities should look towards emerging markets and high yield bonds, property and infrastructure.
“International Biotechnology Trust offers global, well diversified exposure to the biotechnology sector, with a focus on focus on mid- and small-cap companies,” he said, while the iShares Global Clean Energy ETF is the best option to gain passive exposure to global clean-energy-related businesses.