Markets have started 2023 with a bang, as better than expected inflation data takes the pressure off central bankers.
Yet inflation remains high so what should investors do?
Well the starting point for any investment strategy is to help investors reach their goals and the best way to do that is grow the purchasing power of wealth. This is why equities are the bedrock of portfolios as they generate income that grows faster than inflation.
Recession is the main risk with equities because this is when companies are most likely to collapse and dividends to be cut. When this happens share prices can fall heavily and behavioural biases drive investors to sell out after big falls and miss out on the recovery.
To diversify this recession risk, investors need other assets that pay income and capital back, no matter what. Government bonds remain the best fit for this role but are also the asset most vulnerable to an inflation shock because the coupon and capital payments are fixed.
The unprecedented series of inflation shocks since 2019 have not fundamentally changed the role of equities as the primary sources of return and government bonds as key diversifier for the main equity risk. The real lesson of 2021-22 is that valuation does matter and there is a link between valuation and future returns.
Bonds were very overvalued and so prices fell heavily as investors priced in more realistic inflation assumptions and central banks acted forcefully to suppress inflationary pressures.
Valuation was also the key driver of equity returns in 2022, with the unwinding of extreme speculation and overvaluation in innovation theme investments, from cryptocurrencies to loss-making start-ups and even the global dominant franchises epitomised by the Faang group of companies (Facebook, Amazon, Apple, Netflix, Google).
After a tumultuous 2022 and a roaring January 2023 does the path of inflation still matter for investors?
The answer is yes because UK inflation is still very high: the latest annual inflation rates are 13.4 per cent for RPI, 10.5 per cent for CPI and 6.3 per cent for core CPI excluding food, energy, alcohol and tobacco, according to January data from the Office for National Statistics.
Drivers of inflation
To understand what may happen next, you need to zero in on the forces pushing up prices.
Looking back over the past three years there are clear phases that have led us to this point.
In 2020 a huge excess of demand over supply was created by governments in response to the Covid-19 outbreak. Lockdowns reduced the capacity of economies to produce goods, on top of sickness that stopped work.
Massive spending, tax cuts and cheap money from governments spurred demand, which was channelled into goods because entertainment, travel, eating out and other services were simply not available during lockdowns.
The second phase was the surge in energy prices, starting as a normal rebound from the extreme lows of 2020 when prices fell to $20 (£16.54) for US oil.