Interest Rates and Inflation – a delicate recipe

by Alexander Beard, on Jul 24, 2017 5:34:34 AM

I like to compare investment portfolios to recipes, not because I am a good cook - I have (without any exaggeration) made people retch with my dishes - but because I imagine they work in a similar way. This is because a tiny pinch of a powerful ingredient can make a huge difference.

Starting in the kitchen, a slight increase in the amount of cinnamon or cloves could turn a pleasant flavour into something completely unpalatable – and for different reasons (I understand that cinnamon is at the sweeter end of the scale and cloves are more bitter). Similarly, a complete absence of them could make for a very bland experience. Crucially it is the effect on all the other ingredients that matters, since you would not consume these flavourings on their own, you would add them to other ingredients in a Moroccan tagine or a mince pies, so I am told.

We now move to the office, where investment portfolios are constructed. This is where we pay close attention to changes in inflation and interest rates. Inflation can be a sign that the economy is gaining momentum: profits rise, they feed wages, which in turn stokes up prices – a virtuous cycle until it gets out of control. Controlling inflation usually entails raising interest rates, which makes it harder for businesses to raise capital and slows individual spending due to higher mortgage payments (for example).

It is a delicate balance. Most central banks (the people who set interest rates) in the developed world target an annual inflation rate of around 2%. When it looks like it might creep over this key threshold they tweak up interest rates, much below and they could lower rates, which sounds easy enough. Except that some inflation is due to exceptional circumstances and will wash through the system. The sudden drop in the value of Sterling raised some prices through higher import costs, but its effect will not be shown in inflation a year after the drop. Swings in fuel prices can also distort the figures. Inflation without wage growth could be a sign that short term factors are stoking inflation. Setting interest rates with this background is a much harder task.

These factors can have a huge impact on the balance of investment portfolios. Some assets, such as Government Bonds (Gilts), can be very sensitive to changes in interest rates. Rising rates generally force Gilt values lower. Other assets can benefit – cash provides better rates with higher interest rates of course. And more recently stock markets have taken interest rate rises as a sign of confidence, but if you take rates too high it can send markets tumbling.

Different parts of the globe are experiencing different rates of inflation, they are at different levels of reaction. So the US and UK seem to have upward pressure on interest rates, Europe is getting there, but on the opposite side of the globe the situation is almost reversed in some countries.

Blending all these considerations is tricky. These two powerful ingredients, inflation and interest rates, can have a huge effect on which assets to hold, which parts of the globe to focus on, and which styles of investment management are most likely to succeed. When inflation bites, whether you are in the office or in the kitchen, we need to study the reaction hard – are portfolios retching or savouring? Often it is purely a matter of individual taste which, in the investment world, translates into your appetite for risk.

As long as you are happy with the returns and the level of risk, then you have the right balance.

The value of investments can fall as well as rise, your capital is at risk.

Andrew Moore
Investment Director and Partner

Topics:EuropeInflationInterest RatesInvestmentsUKUSA