While the attention of many British investors has been riveted on the turmoil in sterling and UK government bonds, they should not ignore the global context in which these ructions have been taking place.
Led by the US Federal Reserve, there has been a concerted drive to higher interest rates in the advanced countries as the central banks respond to the peaks in inflation.
They seek to correct the errors of 2021 when they persevered with ultra-low rates and plenty of extra money creation for too long. From New York to New Zealand and Brussels to Seoul, official interest rates have been on the rise. This has led to bond sell-offs, pushing longer term interest rates upwards in sympathy with the official short rates. I kept the fund out of longer bonds in anticipation of these moves.
Only China and Japan have stayed out of these changes. They kept inflation down, as they limited the expansion of their money supplies, keeping credit and prices under better control. Japan still borrows money for around zero interest.
The danger now is that central banks will switch from making the error of too much money and credit with rates too low (which is inflationary) to too little money and credit with rates too high — causing a recession. When asked about this, the Fed replies that tough medicine is needed to cut inflation, their only current priority.
This year, the 10-year rate of interest on US government debt soared from 1.65 per cent to a peak of 3.94 per cent on September 27. This has forced US mortgage rates up over 6 per cent and led to a sharp decline in the housing market.
The European Central Bank has been late to stop bond buying and to raise rates, but the German 10-year state borrowing costs have still risen from a negative figure at the start of the year to a peak of 2.2 per cent recently. With German inflation over 10 per cent that still looks low and means more rate rises to come.
Both the Fed and the European Central Bank have clearly signalled their wish to raise rates further, which helped fuel the hectic September sell-off. As a result, the interest rate on very long-term borrowing is often now lower than the interest rate on shorter-term bonds. This reflects the growing market view that we are heading into a sharp slowdown of activity which may become recession in some countries.
Once a recession has been long enough and deep enough to satisfy the central bank that inflation has been killed, they will have to lower official interest rates again.
As we edge towards the northern winter, markets need to worry about the continued supply problems in energy markets. The EU has just announced policies to cut electricity demand at peak periods, to cap prices and to tax excess profits.
If the winter is cold — with too many windless days — there may need to be tougher moves by the EU to ration power, with more difficulties for industry in general and high energy using businesses in particular. The US is in a stronger position with a surplus of gas for its own needs. The surveys indicate slowdown or recession with industrial orders weaker.
This background has been unhelpful for most share markets as well. The clear intent of central banks to slash demand, money and credit in the system implies lower turnover growth, falling profit margins and lower profits for many businesses. The market is also unable yet to put a clear and believable timeline on how long the central banks will pursue tough policies, and when they will have to relent to stop a slowdown becoming a slump.
The portfolio has maintained a commitment to shares as a balanced fund has to, with an emphasis on a widely diversified portfolio around the world index. Switching out of Nasdaq, the US technology index, helped control losses, with the world index having some sectors like energy that have done better in these difficult conditions.
The fund still retains some of its specialist exchange traded funds offering exposure to the digital revolution and the green transition. While activity among the underlying businesses in these areas has continued to grow, their overall performance has suffered from markets discounting future growth in revenues and profits at higher discount rates to reflect rising interest rates. Clean energy and battery technology are the best performers as countries try to force the pace of renewable investment.
We have had such a sell-off in bonds that I am starting to commit some of the fund’s cash into 10-year Treasuries. The world investment markets will not perform well until the US alters policy from one of promoting recession. European markets remain rightly nervous about the Ukraine war and disrupted energy markets.
As I write this the market is rallying on hopes of some limits to rising rates as evidence mounts that inflation will fall next year. Bonds should be the first to turn for the better.
If we are fortunate the Fed will start to relax before triggering a deep recession. If not, the Fed will relax more at a later date. Either way, inflation will be a lot lower and longer term interest rates will then fall.
Sir John Redwood is chief global strategist for Charles Stanley. The FT Fund is a dummy portfolio intended to demonstrate how investors can use a wide range of ETFs to gain exposure to global stock markets while keeping down the costs of investing. [email protected]
