Market turbulence: inflation ‘fears’ give investors the jitters

Bond and stock markets have had a troubled few weeks as investors watch for signs of an economic recovery which could finally end the near decade-and-a-half of record low interest rates.

The recovery in countries from the US to China, spurred by increasing vaccination programs, have sparked comments from central banks about ending the unprecedented support for markets. This in turn has caused bond values to fall, with a knock-on effect in the stock market as risk-averse investors cash out.

But why is this happening when global economic news is getting more positive?

Well, it is precisely because of positive economic news that investments are suffering. This comes down to how investors anticipate changes to both interest rates and other support from central banks around the world, including the US Federal Reserve and the Bank of England.

Economic recovery

As economies recover from the coronavirus pandemic and countries open up it is widely expected that cash – which has been pent up by a lack of anywhere to spend – will be unleashed. In the UK, for example, households saved £18.5 billion in January this year alone – an extraordinary amount of money. When this cash is let out of lockdown, it is likely that prices will rise faster than normal as the economy balances supply and demand of goods and services. This means, essentially, that inflation is going to increase, possibly by up to 2-3%.

This is where the ‘fear’ in markets stems from. If inflation rises significantly central banks may be forced to take action and they only have a few things they can do to quell inflation, the primary one being to raise interest rates. Raising rates can cool down an overheating economy as it encourages more people to save their money instead of spending it, thanks to increased savings rates from banks. Plus, if central banks raise rates this makes certain investments less attractive than simple savings accounts where money is guaranteed. That causes the value of bonds to fall, and the yields of bonds to rise. This reflects that the company – or government – issuing the bond has to offer a higher return to compete with savings accounts and incentivise an investor to lend them their money.

Why are bonds and stocks both falling in value now?

In recent times both bonds and stocks have risen in value. This is down to an excess of ‘liquidity’ in markets. Essentially, there is so much free cash looking for somewhere to invest, so both types of investment soak it up, causing more growth in values. The opposite is true when that liquidity dries up. When this happens, cash retreats away from those markets and both – as we are seeing now – experience falls. This sends bond yields higher as explained previously, while the prices of bonds and shares go lower. In normal circumstances it wouldn’t be a bad thing to see rising yields on bonds. Many investment institutions anticipate and plan for this eventuality in the wake of an economic crisis.

But right now, yields are shooting up too fast – reflecting a market that has become overly sensitive to the changing conditions. In essence ‘fear’ has overtaken the market in anticipation of central banks, most notably the US Federal Reserve, raising its interest rates to combat spiking inflation. Stocks are also falling as more conservative money moves out of company shares and into either relatively safer bonds, or even into cash as investors attempt to avoid losses.

What you should do about it

In short, nothing. Investing your personal savings and wealth is a long-term activity. It is not worth worrying about short-term issues in markets taking place over a matter of weeks when your horizon is ten years or more ahead. Selling out of investments when markets are falling is never advisable as this can crystalise losses, leaving a portfolio permanently worse off. If anything, it is a good time to put more money into a portfolio to take advantage of temporarily cheaper investments.

If you have any concerns about your portfolio or want to discuss any of the themes in this article, don’t hesitate to get in touch with your financial adviser for more information.