Over the past year, the world’s major central banks have executed a breathtaking handbrake turn. During this period, they have shifted their stance from signalling that elevated inflation reflects supply side bottlenecks and will prove transitory – with only a moderate adjustment to interest rates required – to stating that inflation is now a clear and present danger and needs to be dealt with by a rapid and steep path of interest rate rises.
There is an adage that a responsible central bank should always remove the punchbowl from the party just before it goes into full swing. However, armed with the benefit of hindsight, it’s clear that this year’s market hangover supports the view that central banks should have begun tightening monetary policy more rapidly.
Clearly, they could not have foreseen the war in Ukraine, but it took several months after the Russian invasion for there to be a recognition that the second-round effects of rising prices could begin to pose a threat to economic stability.
In addition to supply constraints and commodity price inflation, labour markets are playing a key role in central bank thinking.
Despite a rapid rise in the cost-of-living, large numbers of workers who have withdrawn from the labour market in recent years (a process accelerated by Covid) have not yet retuned to work.
This is creating tight conditions in the jobs market and could lead to wage push inflation which, if left unchecked, could echo the experience of the 1970s.
Against the background, at their November policy meetings, the US Federal Reserve and the Bank of England hiked their key policy rates by 0.75%, signalling more to come, with the Bank also beginning to unwind its quantitative easing policy by selling the government bonds it had previously bought back to the market.
Elsewhere, the European Central Bank has also embarked on a course of 0.50% rate hikes. The Bank of Japan, still in the shadow of its longstanding battle against deflation, has been the only major central bank reluctant to join in.
This seismic shift in the interest rate landscape has had a similarly profound impact on financial markets this year. Ballooning bond yields have caused a rapid de-rating of equities, particularly those with the highest earnings multiples, and a balanced portfolio of equities and bonds will have posted its worst returns for more than 50 years.
This year’s sell-off in markets has created a silver lining for the long-term saver able to make ongoing contributions to an investment portfolio. The earnings yield on global equities is now 7.5% and the yield on global bonds is 4%.
Using a simple back of the envelope approach, these suggest that the long-term prospective return on a 60:40 equity/bond portfolio should be in the region of 6%, a full 2% more than would have been the case 12 months ago. So much for the long term.
What about 2023?
Assessing the path of interest rates will play the key role in gauging how financial markets will perform over the next 12 months.
Our expectation is that once monetary policy turns slightly restrictive (roughly another 1% from here) bonds and equities will be able to look beyond the peak of the interest rate cycle and feel comfortable that weaker economic activity will cool inflation.
In this way the twin headwinds of inflation and higher interest rates will be removed and a platform for much better performance from a balanced portfolio will be created.
If this scenario proves correct, a balanced portfolio should return in the high-single digits in percentage terms. However, left tail-risks are likely to remain exceptionally elevated.
For example, we don’t know how the war in Ukraine will develop, whether central banks will hike rates too far and create a deep and lasting recession or if further dangerous pockets of financial market leverage will be unearthed by the ongoing removal of monetary policy stimulus.
Jonathan Cunliffe is managing director of investments at The People’s Partnership, the provider of the People’s Pension.
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