The new year saw a swift and sudden return to volatility as investors turned their attention away from the Covid pandemic and onto a new set of worries, with inflation and interest rates at the forefront and the Russian aggression towards Ukraine in the background. The temporary and transitory nature of inflation, which many central banks and some analysts had predicted, remains stubbornly high and still on the increase and although the comparisons will improve from spring onwards it is beginning to cause some distress to both consumers and corporates. The rapid economic pandemic recovery, while welcome, is further adding to the inflationary woes. Indeed, the IMF is predicting that the UK will be the fastest growing major economy in 2022 with a 4.7% increase in GDP, which follows on from last years 7.2% rise.
While winning the gold medal is to be applauded, it also comes with a heavy price, with the likelihood of more aggressive monetary policy in the shape of interest rate increases. The UK is also facing the problem of a more acute labour shortage following the Brexit decision and the pandemic, with many EU citizens deciding to return to their native countries, at least temporarily. The Bank of England is likely to increase interest rates this week to around 0.5% which would be the only back to back consecutive moves since 2004, in an attempt to combat the inflationary pressures.
However, it is difficult to see how this could address the underlying problems of soaring energy prices, supply chain issues and rising commodity prices which are global matters and largely immune from UK moves. With the US on a similar path investors are concerned that monetary policy may now become too tight too quickly and it could be that after such a long period of extremely low interest rates and a splurge of quantitative easing the good times may be over; while these are rational concerns and mistakes can be easily made in an unpredictable environment, it seems to me that policymakers are doing what is required and some equity markets are simply reacting to a bout of profit taking following some unrealistic valuations.
In the US, technology stocks seemed to have defied gravity for some time now and the interest rate moves in America have been the catalyst for a sharp sell off. Many of the NASDAQ component share prices have been in decline for some months, the falls masked by the continued advance of the few mega stocks such as Alphabet and Microsoft. Recent profit numbers from these behemoths have confirmed the rude health which still supports them and their growth prospects and although some further profit taking can not be ruled out, they are now moving into more realistic valuation areas. As for geopolitical events, the Russian troop build up on the Ukrainian border looks more and more ominous. It may well be that any actual incursion will be limited and could even be swift, but it could have a short, sharp impact on energy prices in particular which could roil markets, albeit likely short lived. However, it seems unlikely to have any severe or protracted economic impact as Europe needs Russian energy and Russia needs Europe’s cash but clearly there could be lots of rhetoric which may aggravate the situation in the shorter term.
Finally, UK equities seem to be on many global investors buy lists at the moment, having been unloved for much of the past 5 years. Those lower growth, traditional sectors of the economy which the UK is so rich in suddenly have significant recovery potential, coupled with lower valuations and higher yields than most other world markets. There is certainly no reason why UK equities cannot continue to advance but there are undoubtedly headwinds which may present some shorter term obstacles.
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