With inflation falling, why is it still a major risk factor for investors? Giles Coghlan, chief market analyst, consulting for HYCM, examines the current economic situation and its impact on how investors are adjusting their investments.
It is common knowledge that, for much of 2022 and the first few months of 2023, the global economy has been grappling with a huge surge in inflation. As a result, this has unleashed countless economic challenges that have demanded the attention of all participants of the world of investment, from central bank policymakers to retail investors.
In a bid to bring the rate of inflation down to its 2% target, the Bank of England (BoE) has embarked on a rapid interest rate hiking cycle that has raised the base rate by 4.4% since December 2021. And, with inflation not falling as sharply as the markets had predicted in April 2023, it’s likely that interest rates will go even higher at some point this year.
Clearly, many of the inflationary pressures that have been boosting prices are maintaining their grip on the markets in the current climate. So, how is this impacting investor sentiment?
Inflation still a major risk factor for investors
Recent research commissioned by HYCM found that one in two (50%) investors continue to see inflation as one of the top three risk factors to their investments, while 22% view it as the most prominent risk in the current climate. But, with inflation falling to single figures in April, why is this the case?
Firstly, the majority (56%) of investors now think that inflation is ingrained in the economy and will be difficult to reverse, underscoring a lack of confidence in the efficacy of the BoE’s cycle of interest rate hikes as a means of curbing surging prices. Consequently, a mere 31% believe that the UK government will be able to fulfil its commitment to halve inflation by the end of the year – given the prevailing economic headwinds, this sentiment is understandable.
While inflation’s drop from 10.1% to 8.7% last month was significant at face value, it would be misleading to suggest that the economy has cooled to the extent that we can say that inflation has peaked. Instead, this decline can be primarily attributed to last year’s substantial price increases falling out of the annual comparison in what economists refer to as ‘base effects’, thereby skewing the interpretation of the data.
Of course, some optimism can be taken from the fact that the headline print is falling, however other economic indicators suggest we are far from being out of the woods when it comes to combatting inflation yet. For instance, the UK labour market is still incredibly tight, while wage growth continues to exceed expectations, adding weight to growing fears that we are in a wage-price spiral. Indeed, as average pay figures recorded a substantial increase of 6.7% between January and March 2023, the BoE are likely to exercise caution and wait for a decline in wage growth before considering a more accommodative monetary policy stance.
The persistent inflationary pressures in food prices are another significant cause for concern. Despite a marginal 0.1% decline last month, food price inflation still stands at a substantial 19.1%, marking it as the second-highest rate of increase in over 45 years. This poses a particular threat to investors in stocks and shares, as elevated food prices are likely to constrain consumer spending. Consequently, businesses may face the dual challenge of rising operational costs and diminished profit margins, ultimately resulting in potential declines in stock market valuations.
Elsewhere, core inflation has surged, rising to 6.2% in April from 5.7% in March. This increase indicates that prices for most goods and services continue to rise, even when more volatile items like food and energy are removed from the equation. The persistence of this upward trend in prices suggests the existence of a deeper inflationary trend within the economy, further corroborating investors’ concerns about the entrenchment of inflation.
Further action from the BoE is needed
In the build-up to the release of the latest UK CPI data, Governor Bailey indicated that the BoE would not be afraid to hike rates even further should inflationary pressures continue to hamper the economy. The current economic conditions outlined above clearly necessitates further action from the BoE.
Although investors are broadly confident that raising interest rates is the right thing to do, many have concerns about the potential impact of further rate hikes. Following the recent failures of financial institutions such as Silicon Valley Bank (SVB) and Credit Suisse, for instance, a notable proportion (43%) of investors believe that further rate hikes risk compounding weakness in the banking sector and instigating banking contagion.
Meanwhile, another significant number (44%) of investors identified slow economic recovery and sluggish grown as one of their primary concerns. This is perhaps justified, given that the International Monetary Fund (IMF) is forecasting a meagre (0.4%) growth for the UK economy in 2023.
Despite these concerns, only around a third (35%) of investors said that they thought the current bank rate was too high, indicating that their fears surrounding further economic tightening are mainly due to their concerns about the banking system. It’s also possible that investors simply see low growth as a more favourable scenario than rampant and entrenched inflation.
With the markets already pricing in a peak of 5.5% for interest rates, further economic tightening is looks more like an inevitability than a possibility in the coming months.
How are investors adjusting their investments?
With inflationary pressures still in place, and the likelihood of further interest rates hikes increasing, the HYCM survey also provides some valuable insights into how investors are adjusting their investments in the current climate.
Somewhat surprisingly, it seems that a relatively small portion of respondents (30%) have actively diversified their investments to safeguard against market volatility. However, a significant proportion (43%) expressed confidence in the resilience of their investments. This suggests that they maintain faith in the long-term prospects and potential recovery of their portfolios and believe that any losses they experience in the near term could be recouped in the long run.
In contrast, 26% of investors opted to embrace higher risk in their investments. These investors may be employing a ‘buy the dip’ approach, seeking to take advantage of the recovery in currently weakened financial markets. Nonetheless, it is vital to be aware of the potential consequences of taking on more risk in such a volatile and uncertain economic landscape.
By way of a brief summary, it’s clear that investors generally have some support for further rate hikes to drive inflation down, but they also harbour valid concerns about the potential repercussions of further monetary tightening on the broader economy and banking system stability. While it’s likely that further volatility is yet to come, investors should carefully consider their individual circumstances before attempting to navigate what could be an increasingly turbulent economic landscape.
* The market research was carried out between 1st and 9th May 2023 among 2,000 UK adults via an online survey by independent market research agency Opinium.
