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Inflation And What It Means For Asset Allocation, Markets
13 September 2023
The rises in interest rates by a number of major central banks have been a jolt to wealth advisors and their clients who had been used to more than a decade of ultra-low rates. Rising inflation – driven by a variety of causes, such as massive central bank quantitative easing – revived unwelcome memories of the 1970s and 80s, and the struggles to contain it. The return of inflation has upended asset allocation, risk management, and the goals of HNW individuals. It has also come at a time when other big trends in investment, such as ESG, have been powerful, and it has impacted these. Recently, inflation reached multi-year highs due to several factors. During the pandemic, central banks injected significant quantitative easing stimulus into economies, especially the Federal Reserve in the US. Stimulus funds from the Biden administration further exacerbated the situation.
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These events led to a significant increase in the money supply amid supply-side shortages caused by the pandemic. The war in Ukraine further increased inflation, with food and energy prices skyrocketing. In Britain, Brexit-induced labour shortages and rising wages worsened the inflation situation. Once wage inflation sets in, it becomes difficult to curb and a driver of core inflationary pressures.
Eminent economists like Mervyn King and Andy Haldane argue that central banks underestimated the monetary impact of quantitative easing and developed blind faith in the Modern Monetary Theory (MMT) inflation concept. In the MMT framework, inflation becomes a concern only when the economy reaches full employment and productive capacity. They propose that taxation can be used as a tool to control inflation. This miscalculation has led to concerns that the current tightening cycle may not be enough to control inflation, especially in the UK, where labour shortages have been particularly acute.
The risks of over-tightening monetary policy are substantial and include business failures, mortgage foreclosures, unemployment and recession. Central banks may adopt a more conservative approach due to criticism of their role in stoking inflationary pressures. However, excessive tightening can also be detrimental, as it takes 18 months to two years for the full impact of interest rate increases to materialise.
Confidence in central bank modelling has been undermined as they initially predicted inflation to be transitory rather than structural. The Bank of England has enlisted the help of Ben Bernanke, former chair of the Federal Reserve, to examine their modelling and recommend changes.
With faith in their models shaken, the Bank of England now makes interest rate decisions based on near-term indicators, analysing monthly data point by point. This cautious approach has drawbacks. It's akin to walking while looking at one's feet, leading to potential collisions with unforeseen obstacles, like walking into a lamppost.
Overall, the central banks face a delicate balancing act in managing inflation and interest rates, and their decisions will have significant implications for the economy, people's livelihoods and investment decisions.
The resurgence of inflation and the recent interest rate hikes have substantial implications for the private equity and funds industry, as well as international financial centres (IFCs) worldwide. As inflationary pressures continue to mount, investment decisions become more complex, and portfolio managers must adapt their strategies to navigate this uncertain economic environment.
Market volatility and asset valuations
Heightened inflationary pressures can lead to increased market volatility, impacting asset valuations across various sectors. As prices fluctuate, private equity and funds may experience challenges in accurately valuing their investments, particularly in sectors sensitive to inflation, such as commodities, real estate, and energy. Additionally, investors may witness a shift in the performance of different asset classes, requiring agility in asset allocation to manage risk and capitalise on emerging opportunities.
Interest rate sensitivity
The trajectory of interest rate hikes in response to inflationary pressures directly affects the private equity and funds industry. Rising interest rates can result in higher borrowing costs, affecting leverage levels and financing options for acquisitions and investments. Funds with significant debt exposure may experience increased interest expenses, impacting their overall profitability. Moreover, IFCs, being hubs for global capital flows, may experience shifts in their competitiveness as interest rate differentials influence fund flows and investment attractiveness. Still there is a silver lining in the inflation cloud for some. Banks in IFCs have struggled with profitability in the era of ultra-low interest rates but are finally seeing improved margins and profits whilst rewarding savers with higher returns.
Portfolio diversification and inflation hedges
In response to the evolving inflation landscape, private equity and funds may consider adjusting their portfolio diversification strategies. Investors may seek to include inflation hedges, such as inflation-protected securities, commodities, or real assets, to safeguard against the erosion of real value in their portfolios. Diversification across geographies and industries becomes crucial to mitigate concentration risks and capitalise on regions or sectors better positioned to withstand inflationary pressures.
Regulatory scrutiny and reporting
As inflation concerns persist, regulators may intensify scrutiny on investment practices and risk management within the private equity and funds industry. Investors may face increased reporting requirements to provide transparency on strategies to manage inflation-related risks. IFCs may also revise their regulatory frameworks to ensure the industry's resilience in the face of inflationary challenges and to maintain their global standing as reliable financial centres.
Peak inflation presents a dynamic and challenging landscape for the private equity and funds industry and IFCs. As inflation theories remain contested, careful risk assessment and adaptation of investment strategies become paramount. The industry must be prepared to navigate the uncertainties, leverage diverse inflation views to make informed decisions, and remain agile in managing portfolio risks to ensure sustainable growth and value creation in the face of inflationary pressures.
For IFCs, proactively addressing market volatility and evolving regulatory demands will be instrumental in maintaining their status as attractive and competitive financial centres amidst the shifting economic landscape.
The rises in interest rates by a number of major central banks have been a jolt to wealth advisors and their clients who had been used to more than a decade of ultra-low rates. Rising inflation – driven by a variety of causes, such as massive central bank quantitative easing – revived unwelcome memories of the 1970s and 80s, and the struggles to contain it. The return of inflation has upended asset allocation, risk management, and the goals of HNW individuals. It has also come at a time when other big trends in investment, such as ESG, have been powerful, and it has impacted these.
Recently, inflation reached multi-year highs due to several factors. During the pandemic, central banks injected significant quantitative easing stimulus into economies, especially the Federal Reserve in the US. Stimulus funds from the Biden administration further exacerbated the situation.