Investment Viewpoint: Inflation back in focus

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Markets and macro insights with Bernard Swords, Chief Investment Officer

Key takeaways:

1. Rising energy prices have reignited inflation concerns, raising the prospect that interest rates may need to remain higher for longer.
2. Government bond yields continued to climb across Europe, creating a challenging backdrop for fixed income markets and reinforcing the case for shorter-duration bond exposure.
3. The US economy remains resilient, with strong business activity and better-than-expected employment data pointing to continued above-trend growth.
4. Our outlook remains unchanged, with positive economic growth supporting a preference for equities over bonds despite ongoing market volatility.
5. Attention now turns to the ECB meeting, where investors will look for guidance on the future path of interest rates.

How did markets perform last week?

• Financial markets experienced a more subdued week, with investor attention increasingly focused on rising energy prices and the implications for inflation and interest rates. Brent crude oil rose to around $95 per barrel during the week, while natural gas prices in Europe also moved higher. As a result, concerns have re-emerged that inflation could prove more persistent than previously expected, creating challenges for central banks as they seek to bring price pressures under control.
• The impact of higher energy prices was most evident in bond markets. Government bond yields continued to rise across Europe, with German government bond yields reaching levels not seen since 2011 and French yields climbing back towards levels last experienced during the global financial crisis.
• Higher yields reflect growing expectations that interest rates may need to remain elevated for longer. Some economists now anticipate several further interest rate increases in the euro area over the coming year as policymakers respond to inflationary pressures. This was not helped by the CPI release from the region showing core inflation stuck at 2.4% on a year-on-year basis.
• Rising bond yields are also prompting investors to consider the increasing cost of borrowing for governments and businesses. This has created further pressure on fixed income markets, resulting in another difficult week for many bond investors. Within our portfolios, we continue to favour shorter-dated bonds and have limited exposure to areas of the bond market that are particularly sensitive to higher interest rates. While this approach cannot eliminate market volatility, it has helped provide some resilience during a challenging period for fixed income assets.
• Equity markets were relatively stable over the week, producing little overall movement. However, the increase in bond yields remains an important consideration for investors. and a sustained rise in yields from here may limit the potential for equity markets to move higher in the near term.

What were the key economic developments last week?

• Economic data released during the week remained encouraging, particularly in the United States. Business surveys, the ISM’s, covering both manufacturing and services activity continued to indicate expansion, with new orders showing notable strength. New orders are often viewed as a leading indicator of future economic activity, suggesting that demand remains healthy across many parts of the US economy.
• The most closely watched economic release was the US employment report. Investors had been concerned that signs of weakness might begin to emerge in the labour market, but the data painted a more positive picture. Job creation during the month exceeded expectations by over 100,000, while previous months’ figures were revised upwards. Taken together, these developments suggest that the US economy continues to demonstrate resilience and remains on a path of above-trend growth.

What does this mean for our investment outlook?

• Current market developments remain broadly consistent with our investment outlook. We continue to believe that economic growth is likely to remain positive across much of the global economy, supporting our preference for equities relative to bonds.
• At the same time, we remain cautious on the outlook for interest rates and therefore continue to favour shorter duration fixed income exposures. While higher interest rates can create market volatility, we do not currently believe that the recent rise in yields is sufficient to derail the broader economic expansion.

The week ahead: what to watch out for

Looking ahead, investors will focus on a number of important events in the coming week. Inflation data from the United States and China will provide further insight into the direction of global price pressures. However, the key event will be the European Central Bank meeting. While a further interest rate increase is widely expected, investors will be particularly interested in any guidance regarding the path of policy over the months ahead.