WeekWatch

Volatility continued in equity markets last week, as economies struggled with ongoing inflation.

In the UK, the Office for National Statistics revealed that CPI Inflation rose by 9.0% in the 12 months to April 2022, the highest rate recorded in 40 years.

The Bank of England (BoE) has warned that inflation is likely to continue to rise in the near-term, potentially breaking 10% this year.

The FTSE 100, which has been amongst the most resilient markets so far this year, declined by -0.4% over the week.

Oliver Wayne, Senior Vice President – Manager Research, at investment consultancy Redington explained why high inflation can cause issues for equities: “Inflation presents challenges for companies. It impacts their sales, margins and the multiple they trade on. It erodes consumers purchasing power which reduces their ability to spend, which impacts company sales. It increases costs which reduces margins.”

Wayne notes the current environment is likely to see a different style of shares perform better: “In low inflation environments, value style investing has underperformed the market, which is what we have experienced over the last decade. However, in high inflation environments, defined as over 4.4%, it has meaningfully outperformed the market. This shouldn’t surprise us because these value companies are by definition lower duration investments where you own more levels of cash, earnings and assets for every pound invested.”

This is an important reminder of the importance of diversification, as those heavily concentrated on one style of investing might do well in some circumstances, but could struggle when the market changes. Someone heavily invested in tech stocks will likely have had a tough year, with the likes of Apple, Alphabet, Microsoft and Tesla all down over 20% year-to-date. This is why we seek to invest in a variety of shares and asset classes, to help smooth out some of this volatility.

It is also a useful reminder of the value of active managers, who can identify trends such as this, and invest accordingly.

In the US, a bleak economic outlook as a backdrop caused equity markets to retreat again last week. In the US, the S&P500 slumped by -3.1% after Federal Reserve Chairman Jerome Powell stated that the Bank is prepared to take action if needed to tame inflation. The S&P 500 has now fallen for seven consecutive weeks, its worst run since 2001.

This included a 4% drop on Wednesday, its largest one-day drop since the start of the pandemic in March 2020, as large traditional retailers Target and Walmart both fell after posting disappointing results.

The situation wasn’t helped by unemployment data released towards the end of the week, which revealed 218,000 initial jobless claims, almost 20,000 above expectations. This fed into fears that the US could experience a recession this year.

Since the start of the year, both the S&P 500 and NASDAQ are notably down. While this short-term volatility might be concerning for investors, it is important to remember that ups and downs are to be expected. Adrian Frost from Artemis points out: “Since 1957, a five-month decline of over 15% in the S&P has led to a median return a year later of +20% (though not in 2001 and 2008).”

While past performance is not indicative of future performance, this statistic serves as a useful reminder that while it might be tempting to leave the market during tough times, periods of heightened volatility are temporary, and exiting the market could see you miss out on any bounce effect at the end of it.

Dan O’Keefe, Lead Portfolio Manager at Artisan notes: “We have the tendency to look into the market at times of extreme volatility and feel that things are highly uncertain. But they’re equally uncertain at any point in time, and equally as unknowable as any other point in time. When the market is volatile, and stocks are going down, it’s an unpleasant experience.”

“But in my 25 years of investing, one thing just continues to ring true, and that is when things feel very bad and unpleasant, it’s usually the right time to be allocating capital. And that’s usually when the greatest returns (prospectively), will be earned. And it’s not easy to do, but it requires discipline. And I think that’s a lesson that everyone needs to keep in the forefront of their minds in times like this.”

Reminders that the unexpected can derail our plans at any time have been plentiful in recent years.

The ongoing ramifications of the pandemic continue to play out even as the COVID-19 threat slowly recedes, while the effects of the war in Ukraine and the biggest cost-of-living crisis in decades are creating further distress and disruption.

Rapidly rising food, energy and fuel prices have driven levels of inflation up dramatically.

That leaves even less room for dealing with the financial effects of unexpected events closer to home, such as illness, accidents, bereavement and unemployment. It can take just one unfortunate turn of events to threaten the most carefully laid plans, including the savings and investments being built up for the future.

Difficult choices

From raiding emergency savings and cutting expenditure to considering insurance products such as income protection, there are ways of protecting household finances.

But when times are tight, it can be very easy to make knee-jerk decisions that might not be the best course of action. That risk is exacerbated by the anxiety and fear around the financial outlook in many households, and the emotional challenges posed by life-changing events such as illness and bereavement.

“It could be family situations, such as the financial impact of having to quit work or reduce your hours to care for a family member, for example,” says Tony Clark, Senior Propositions Manager at St. James’s Place.

Similarly, it could be a partner losing their job and leaving the household relying entirely on one person’s income. “One thing that often catches people out is what happens if they can’t work,” says Tony.

Is it worth getting income protection insurance or critical illness insurance?

Both are important, although they offer different types of protection. Income protection policies provide pay-outs to help cover outgoings such as mortgage repayments, rent and bills in the event of being unable to work because of illness or an accident. They will cover you for a set amount of time (usually until you retire) and you’ll be paid until you’re either able to return to work or until you reach the end of the term.

Critical illness insurance policies can be complementary, as they provide a lump sum on the diagnosis of certain critical illnesses or medical conditions. This can provide a much-needed financial boost if you’re unable to work or decide you don’t want to.

“People will immediately think of protecting themselves in terms of critical illnesses, but insuring your income that’s funding your savings and investments is particularly important,” says Tony.

The main driver of inflation and what brings it down is the very big, real income shock, which is coming from outside forces and, particularly, energy prices and global goods prices. That will have an impact on domestic demand, and it will dampen activity, and I’m afraid it looks like it will increase unemployment.

UK Bank of England Governor Andrew Bailey warns MPs things could become tougher before they get better.

Artemis and Artisan are fund managers for St. James’s Place.