The past year has been full of political, humanitarian and economic challenges. With the war in Ukraine leading to a surge in inflation, we are currently experiencing a re-programming of the monetary system. In this environment, maintaining the value of our capital is a large challenge. Where should consumers invest in the current economic climate in order to fight inflation, and do the financial markets hold even a small amount of optimism right now?
The world economy experienced a turning point in 2022. The years-long supportive monetary policy has reached a dead end due to inflation, causing central banks to raise interest rates. This surge in inflation was sadly accelerated by a tragedy: war on the European continent. However, one can theorise that this tragic event has served as a handy excuse for central banks to finally escape the endless cycle of negative rates.
Looking at the medium and long term, this could be a healthy turn of events for the world economy, where money and capital once again have positive price, forming the basis for healthy capital allocation and productive economic growth. However, this year we have felt only the short-term effects of this transition from one monetary regime to another: shock and anxiety, of which the financial market is the most vivid reflection. In general, the value of all financial assets is lower than at the start of the year after pricing in the lower short-term economic growth outlook and higher capital cost.
Looking ahead, although the news continues to be filled with worrying events, things are very possibly looking better for investors in the medium and long term. Interest rate products (bonds, deposits, etc.) once again have positive and even attractive yields and the previously unreasonably high valuations in the stock markets (particularly in growth stocks) have disappeared.
How would the financial markets react to a potential escalation of war?
The financial markets and economy are rarely surprised by the same topic more than once. This leads us to believe that the market is currently able to absorb a significantly broader spectrum of military scenarios than last year. However, you don’t have to be a financial professional to see the obvious: if the conflict in Ukraine escalates to new levels, or a real military conflict evolves between the U.S. and China, there will be no winners, and this will also be reflected in the financial markets. The world and financial markets will have to live with this military angle, however, the aforementioned changes to the financial environment and the respective increase in potential returns gives us a certain amount of optimism, at least in the medium term.
Where should I invest to fight inflation?
The uncomfortable truth is that there are no instruments which can fully outweigh inflation without risk. In the U.S. we are already seeing a slowing pace of inflation, and this trend should reach Europe in the first half of 2023. Regardless of the exact inflation figure for the past 12 months, we are now in a fundamentally different situation than before. Bonds and their funds have become a practical alternative for investments. For example, the relatively secure developed country investment grade rating corporate bonds have again become useful in fighting inflation effect, as their yield to maturity in Europe is currently around 3.0% - 3.3% (for illustration, for a five-year term). Portfolios of higher-risk bond funds, which invest in lower-rated company or developing nation debt markets, have jumped on average to a much more impressive 6% - 8% in EUR. However, in this segment, some part of returns must be reserved for the inevitable loan losses in some markets resulting from the more challenging economic growth.
At the same time, the fact that attempts to outpace inflation cannot be successful in the medium term without investing in shares has not changed.
Three recommendations for people thinking about investing
My first recommendation: don’t be afraid of the financial markets. The markets fluctuate and can be incomprehensible at times, but it is the most transparent and effective way to take part in global economic processes and grow your capital over a longer period outside of your direct job or business. Second, you should adhere to basic financial truths. Try to define your long-term financial plan, of which these investments are a part. Understanding your realistic preferred investment period and willingness to live with fluctuations is critical for identifying your optimal risk and expected return combination. Third, diversification (geographic, between industries, between asset classes) is particularly relevant in these changing times. For smaller amounts, investing in investment funds is probably the most logical choice. Finally, build good habits by investing regularly in your chosen tools.