Market Nerves on USA Inflation Risk
Published / Last Updated on 11/05/2021
Stock markets in the UK tumbled today by 2.5% along with Europe, the Far East and North American markets.
Why Did Markets Tumble?
They fell because US inflation figures are due to be published tomorrow and investors are worried about the impact of inflation. Inflation drives materials costs up, wages up, property costs up etc which then has a knock on effect to the prices of goods and services that a business may be outputting to create a ‘vicious circle’. A real risk of profits falling.
Bond Market Risk
The bond market is mainly made up of fixed rate government bond (in UK they are known as Fixed Rate Gilts). Government bonds and gilts are a mechanism where governments borrow money from investors, agree to pay a modestly low rate of interest (coupon) and then at maturity, the face value of the bond matures and is paid back. E.g. £100 invested in 1.5% 20 Year Treasury stock will pay 1.5%pa fixed interest/coupon for 20 years and then the investor gets their original £100 back in 20 years.
Investors are usually happy to lend their money to governments as it is perceived as low risk. If a government could not afford to repay the loan at maturity, they can raise taxes to do so, so the risk of default is relatively low. This is why investors are prepared to accept low, fixed rates returns in exchange for security.
Governments Borrowing Too Much
Covid-19 has created unprecedented levels of government borrowing (except in war time) in the billions and trillions. Supply and demand economics means that an oversupply of available government debt stocks will naturally push prices down. E.g. If there were 200 identical ‘Mona Lisa’s’ then the value would be substantially lower compared to the limited supply of just one.
Investors are also concerned that spiralling debt will force governments to let inflation run free i.e. increase over the coming years whilst investors are locked into investments with low interest, fixed rate returns. In times of high debt levels, governments need inflation. If we have 5% pa inflation for a period of 10 years, this is a compounded rate of 62%. This means government ‘fixed rate’ debt ‘spending power’ of say your £100 invested will be devalued by 62% without the government having to repay it for another 10 years – imagine the real value of your £100 in 20 years? This is what we think governments will do with covid-19 debt. Inflation! Inflation! Inflation!
The Biden “American Rescue Plan” plans to give $1,400 to each low income family (more money to drive the economy) as well as increasing minimum wage over the coming years from $7.25ph to $15.00ph. Wages up equals prices for all goods, services and property up. Inflation! Inflation! Inflation!
With economies also starting to open up as they get to grips with covid-19, pent up demand is starting to be released into the economy. Demand for goods and services rising meaning inflation is on its way. The US is due to publish its own inflation figures tomorrow and that is the worry. Inflation! Inflation! Inflation!
Fixed Rate Bond Market Sell
Selling fixed rate bonds off (as they have no inflation protection) drives markets down, not just your fixed rate investment funds but it also has a knock on effect to stock markets as many professional investors may be geared up in the bond market meaning losses are compounded, forcing the sale of equity holdings profits to cover bond market losses.
Take a Breath
To put this in perspective, the falls today have only pushed stock markets back to their levels of just 7 working days ago. This is still 26% above its year low for FTSE 100 and still over 40% above the year low for the Dow Jones. “Don’t panic Mr Manerwing.”
