It’s been another rough ride for investment markets in recent weeks. Central banks in developed economies have been increasing interest rates, with more likely to follow.
This, combined with talk of ‘fiscal tightening’, has resulted in US markets officially moving into ‘bear market’ territory. Many other stock market indices have been drifting lower and the economic outlook – in the short term at least - is looking gloomier than it was twelve months ago.
But what is a bear market exactly? And why are central banks raising interest rates? What are the implications of this on our finances and our investments?
Read on for an update on what’s currently happening in the global economy and why rising interest rates are making the headlines.
Bulls and Bears
So, let’s start by talking about bulls and bears. These two characters often appear in discussions around economics and investments. So, what do they mean?
A ‘bull market’, or ‘bull run’, is a term used to describe a prolonged period of strong economic and investment performance.
‘Hold on tight - the bulls are on the charge and it's blast off for markets!’
Sentiment during bull markets is optimistic. Investors are enthused by their recent gains and hungry for more. Economic data is often encouraging, and a sense of excitement and exuberance is in the air. Positivity begets more positivity and enthusiasm can be infectious.
The problem with prolonged bull runs however, is that people begin to confuse the period of rapid growth and returns, with ‘normality’. Investors begin to forget that stock market investing is about ups AND downs. Whilst long term investors wait patiently and enjoy their compounding returns, speculators and amateur investors often start pilling in, many with the false expectation that they’ll sell out again ‘at the top’.
The trouble is, you never know where the top is until you’re passed it. Bull markets cannot continue forever and inevitably run out of steam. The latter stages of a bull run can sometimes result in bubble’s forming, which can then ‘pop’, leading to a short sharp retrace, as some of the froth is lost. Those in it for the long haul temporarily give back some of their recent gains and await the next stage of market movements. Jittery amateur investors and speculators often panic and sell to cash, crystalising losses.
So, what about a bear market?
A ‘bear market’, is used to describe a phase during which economic data and stock markets are in decline. Whilst there are no official qualifications for a bull run, officially, a bear market, is where a particular market or economy experiences a decline in value of 20% from a recent peak.
It has been opined that the term bear market comes from the way in which bears attack, with both claws sweeping downwards. The jury is out on this one, but I think the simple fact is that most bears are scary and so can be bear markets…
During a bear market, like a pendulum, sentiment swings rapidly the other way. A gloomy mood descends on investors and economists. Relentless exuberance is replaced by dogged pessimism. Many of the speculators that didn’t panic before, totally lose their nerve now, jumping out of markets and into cash, crystallising further losses and driving markets lower.
However, it's important to remember that bear markets are just another fact of life for stock market investors. Investing and generating returns in excess of cash deposits is not a straight-line romp to victory. We must take the rough with the smooth and ride the ups and downs.
It can sometimes be hard to keep your head however. The media LOVE bear markets and stock market falls. The column inches virtually write themselves and sensationalist headlines are great for engagement and clickbait. As I often note, they love to shout about ‘billions wiped off stock markets’ and ceremoniously roll out the same old ‘stressed-stock-market-trader’ images that they keep on hand. You rarely hear them talk about the billions being ‘wiped on’, when times are good…
US Bear Market
So, it’s official - the US stock market is in bear market territory, whilst other indices have taken a knock.
What about rising interest rates and inflation? How do they figure in all this?
You don’t have to be an economic commentator to know that currently inflation is running hot in developed nations. Even if you lived in a cave with no internet and no local news agents, you’d still feel it in your pocket when you emerged to go shopping (unless you’d gone full hunter gatherer mode).
Inflation measures the rate of increase in the price of goods and services. The past twelve months has seen a perfect storm for rising prices of…well…pretty much everything.
Pent up savings and rapacious post-Covid demand. Supply chain issues, ranging from blocked ship lanes, a post-Brexit exodus of HGV drivers and a near-militant Chinese Coronavirus lockdown. A major conflict in eastern Europe decimating fuel and cereal exports. A global semiconductor shortage, affecting everything from PlayStations to Peugeots. Labour market shortages, with more jobs than people leading to soaring salaries.
Whilst some indicators suggest inflation may have peaked, others suggest it is far from under control in the worlds developed economies.
Banks and Base Rates
This is where central banks step in. Their primary role is typically to control inflation. The Bank of England has a long-term goal of keeping inflation around 2% per annum. For over a decade, it’s been successful in it’s goal, though arguably due to benign inflationary pressures rather than shrewd manoeuvring. With current measures suggesting inflation to be running at around 9% at present, clearly they have their work cut out.
The tool with which central banks seek to control inflation is interest rates. They control a country’s base interest rates, and by manipulating these, they can influence economic activity. This enables them to either breathe on the glowing embers of an ailing economy, or pour water on the raging bonfire when economic activity gets out of control.
So how does this work? By raising interest rates, as they are doing now, this influences the cost of borrowing and returns on savings. Mortgage borrowers on variable rates - or those approaching the end of a fixed term - suddenly find their mortgage payments taking a hike. Theoretically, this gives them less spending power, dampening demand for goods and services and cooling rising prices. The same is true for savers, as if they are getting a more attractive return on their savings, people may be more inclined to keep their cash on deposit rather than spending it.
Basically, rising interest rates should dampen demand for goods and services, helping inflation to fall away, as the opposing forces of demand and supply are brought into balance.
Interest rate policy is however – like most things in finances – a double edged sword. In a rising interest rate environment, businesses pay more to service their debts, whilst they may find themselves with less customers. This reduces economic activity, can result in cut-backs and trigger job losses, all of which hamper economic growth and stock market returns.
In more normal market conditions, it is relatively easy to get the balance right between interest rates and inflation, without having dramatic impact on the economy. A little nudge here, a tweak there… Splendid.
However, with inflation having surged to its highest level since the Margaret Thatcher years, due to the bizarre confluence of inflationary pressures, more drastic action is needed. This is why we’re currently seeing rapid interest rate hikes in the US, Europe and UK, as central banks seek to get the current blaze of rising prices, back under control.
Whilst increasing interest rates will likely curb high inflation in time, too many rate rises can tip an economy into recession in the short-term. Whilst the lesser of two evils compared to long-term high inflation, recessions put the brakes on economic growth. This in turn - much like our aforementioned bear - can put stock markets into a state of hibernation. They often drift lower when news flow is at its gloomiest, before trading sideways awaiting signs of the green shoots of recovery.
What does it mean for our finances?
Well, you don’t need me to tell you that our basic and discretionary spending needs are on the up. Shopping bills are steep. Petrol prices are painful. Energy costs are eye-watering. (British Gas have magnanimously offered to fix our tariff at a mere £3,600 for the next twelve months – how generous). Regardless of your means, I’d strongly recommend revisiting your household budget to ensure you have a close grip on what you’re spending.
If you’re coming to end of a fixed rate mortgage deal, or currently sat on a variable rate, I’d strongly recommend taking advice about your options to remortgage. We don’t give mortgage advice ourselves but can refer you to a good independent broker if you need a recommendation.
On the plus side, savers may see a boost to returns on cash deposits. Banks tend to be quick to pass on rising rates to borrowers, but less to savers, but it'll no doubt start to filter through over the months to come.
For our investments meanwhile, we’ve all felt some pain and may need to don our raincoats and wait for the storm to pass. In the US, a period of recession now looks highly likely. The US stock exchange is where the world’s largest companies reside, so inevitably this will continue to constrain share prices for now, dampening portfolio performance.
In the UK and Europe meanwhile, the outlook is less clear. News flow is turning negative, but the media and stock markets tend to be natural over-reactors and are not necessarily good predictors of recession. As Paul Samuelson once quipped; ‘markets have predicted nine of the last five recessions’… We will have to wait and see how the latest round of rate rises plays out and will be watching the inflation figures closely.
Either way for us as investors, after plain sailing in 2021, it looks like 2022 will continue to be a bumpy ride. However, we will take the rough with the smooth and ride it out as ever. Every storm passes in time and long-term, a diversified portfolio investing in the world’s leading companies is a great way to grow our capital, even if we have to endure stormy seas from time-to-time…
