Editor's letter

How to invest in an environment of rising inflation and unpredictable central bank policy

This week central banker Lael Brainard - a long-term dove - rattled markets by suggesting America's Federal Reserve will unwind quantitative easing faster than expected. John Stepek explains what is going on.

A central banker gave investors a nasty wake-up call this week. It wasn’t one of the usual suspects – Federal Reserve chairman Jerome Powell, or Bank of England boss Andrew Bailey. It was Lael Brainard, who is set to take over as vice-chair of the Fed.

On Tuesday, she warned that quantitative tightening (QT – the process by which the Fed sells the bonds it bought under quantitative easing) will start earlier and be more aggressive than investors had hoped.

Why is this significant? Because when Brainard was nominated to take the vice-chair role by US president Joe Biden late last year, she was widely viewed as a “dove” who would err on the side of loose monetary policy, and had occasionally nodded towards the ideas of modern monetary theory (MMT – funding public spending via unlimited money printing). So much for that.

Markets are starting to wake up

Before you start imagining that we’re heading for a repeat of the early 1980s, with the Fed pushing interest rates well into double-digit levels to crush inflationary pressure, it’s worth noting that central bank resolve has yet to be tested by the market.

The particularly grim tone of news headlines right now, along with attention-grabbing volatility in oil markets, has obscured this fact, but the reality is that most global stockmarkets simply haven’t done that badly this year.

For example, from its most recent high at the start of 2022, to its most recent low in mid-March, the S&P 500 fell by around 13%. That’s a “correction” (down more than 10%), but not a “bear” market (down more than 20%). And since then, it’s rebounded by about 7%, meaning it’s only down around 7% for the year to date.

That might be painful for investors who have been conditioned to “buy the dip”, but it’s hardly a big fall. In the context of a major war in Europe, high and rising consumer price inflation, and even rising interest rates, some might argue that it is positively miraculous.

Of course, this sudden urgency to tackle inflation does rather imply that central banks are already too late. One sign that markets are now taking inflation seriously is that while bond prices have slid (and yields have risen, as a result) gold has performed well.

In recent years, higher bond yields have meant falling gold prices (gold pays no interest, so if bond yields rise, they should become more appealing in relative terms). Yet they have now “decoupled”. As Louis-Vincent Gave of Gavekal points out, “the fixed-income market and the gold market are sending the same message: deflation is no longer the main threat for portfolios”.

Novelty is out of fashion

So investors have to contend not just with rising inflation, but also with a less predictable Fed. That’s not an easy environment to invest in. So stick to tried and tested principles: buy cheap and buy stuff you understand. Novelty is out, and old-fashioned investing is back.

For example, on page 28 John Chambers looks at how technology hasn’t proved to be a magic bullet for the insurance sector as some had hoped, and recommends some rather more traditional Lloyd’s of London insurers instead.

Meanwhile, speaking of gold, on page 18 Dominic looks at why gold-mining stocks have done so poorly relative to gold. More importantly, he wonders if that might change soon, and how you might profit.

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