Inflation, interest rates and what to do as an investor

If we look at the facts; the UK Consumer Price Index (CPI) is up 5.4% from a year ago; the Retail Price Index (RPI) is up 7.5%, the highest since 1991. In the US, CPI is up 7.0% on a year ago, the highest figure since 1982. The market expects inflation to be above the central bank target of 2% on both sides of the Atlantic over the next five years.

There are signs of wage inflation rising, not just in official statistics but also in what companies are saying about their business prospects in earnings reports, which are coming out in January and February. The unemployment rate is 4% in the UK and 3.9% in the US so the pressure on wages may well be higher in coming months.

There is also concern about the ability of central banks to combat inflation with monetary policy. The bond purchasing programme (so called “Quantitative Easing”) that central banks employed post-Covid-19 appear to be at the point of being wound back in, while the UK prepares for a National Insurance rise in April.

In December, the Bank of England raised interest rates in December for the first time since 2018 and the US Federal Reserve Board not only increased the speed with which it intends to reduce its Quantitative Easing but also discussed the possibility of reducing the level of its bond holdings later this year.Historically high valuations for businesses would come under pressure from a collective tightening of consumers’ belts too.Markets also have an eye on simmering political tensions in Ukraine, as troops mass on the border and talk of an allied response, initially through sanctions, gets louder. With Russia controlling vast swathes of supply to the UK and European energy market, there’s potential for further squeezes there, while the political capital and state expenditure required to sustain a conflict would be damaging on economic level.

Likewise, Taiwan. China and the US have been circling around the issue for some time and naval movements in the area tend to generate a lot of headlines. The world’s two biggest economies facing off against each other may be bad news for global investors.

Impact on investors

So, against all that, what should investors do? A 10-year bull market might be about to end, so diversification is once again investors’ best defence against volatility. As financial advisers, it’s always our view that investments are for the long term, so although things might look gloomy now, if one expects the markets to rise in the long term, then there is merit in staying invested. This is central to best practice in financial planning, and you will read a lot in the coming weeks from experienced investors saying the same thing. Even though it might be tempting to withdraw funds when markets dip, withdrawing at this stage ‘crystallises’ losses – i.e. if the market rises and then you decide to invest again in the future when the market has recovered, you will have missed out on rising prices.

In this really simple example, if your £1,000 investment loses 5% of its value but you decide to sell, you have £950. If markets rise and you later reinvest in the same investment when it is valued at £1,050, you’ve lost £100 (£50 of crystallised losses and another £50 to buy back in). Keeping it in the market for that period would earn you £50, so a difference of £150.Investors have enjoyed a long period of positive growth and as we move into a more volatile market, it’s really important to retain a long-term focus on achieving investment goals, while expecting some short-term volatility and muted growth.It’s important to remember that markets are cyclical and investment performance is not guaranteed. However, investments have historically outperformed cash by some way. In this chart, you can see how the investments (UK Equities and Balanced Portfolio) have encountered ups and down, but over a 16-year period (which includes the 2008 financial crisis), there is significant outperformance.However, if you’re concerned about volatility in the market, then regular contact with your financial adviser can help to reassure you. We are in regular contact with your investment manager(s) and can provide additional information and evidence of the benefit of long-term investing.

Furthermore, if your personal circumstances or long-term goals have changed, please contact your adviser to ensure your investments are aligned to your personal goals.Chart data provided by FE. Care has been taken to ensure that the information is correct but it neither warrants, represents nor guarantees the contents of the information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein.

16-year time period selected because it is the first year of consolidated house prices in Scotland and England.