Whisper it quietly, but there are signs that inflation and interest rates may finally be reaching their peak. The Bank of England decided to hold the base rate at 5.25% for the first time since November 2021. Additionally, inflation fell to 6.7% in August, which was lower than forecasted. While inflation is still far from the Bank of England’s target of 2%, it is moving in the right direction.
It’s too early to say if this marks the beginning of a downward trend or just a temporary pause. Bank of England governor Andrew Bailey emphasized the importance of not becoming complacent. However, last week’s data suggests that we may be witnessing the early stages of a turning point.
Investors may feel relieved after months of navigating an unfamiliar and volatile market. Both inflation and interest rates have not been this high since the late 1970s. This environment has made investing challenging, with many questioning its value. For example, why take on the risks associated with investments when government-backed NS&I offers one-year bonds with a guaranteed 6.2% income?
While rates stabilize or decrease, it may appear that we are returning to more familiar territory. However, this is unlikely, and uncertainty lies ahead. Paul Flood, Head of Mixed Assets Investment at Newton Investment Management, warns that we are not out of the woods yet.
Even those who believe that rates and inflation have peaked now face two questions: what will the next phase look like, and how can investors prepare for it?
Bank of England chief economist Huw Pill used a mountain analogy to describe potential future interest rates. The first option is the “Matterhorn” model, where rates rise sharply and then fall rapidly. The second option is the “Table Mountain” scenario, where rates don’t reach such highs but remain elevated for a longer period. Pill prefers the Table Mountain model.
Predicting which model we will experience is nearly impossible. If you believe that the Bank of England has raised rates too quickly, you are more inclined to favor the Matterhorn model. A deep recession caused by rate hikes may force the Bank to quickly lower rates to support the economy. However, many experts believe that inflation will remain above the Bank of England’s target of 2% for years, requiring higher rates.
Uncertainty is the new norm, and investors must accept it. Making significant portfolio changes based on unpredictable macroeconomic factors is not advisable. Instead, portfolios should be well diversified to weather different scenarios.
One option worth considering is investing in gilts, which are UK government-issued debt. These assets offer a guaranteed income, currently around 4.3% for a ten-year gilt. If you believe inflation is under control, this steady income can be attractive. Another option is investing in bond funds that offer higher yields than gilts. Well-established companies often issue bonds with yields higher than government gilts.
Ultimately, the future remains uncertain, and investors must navigate through this period carefully, weighing their risk tolerance and investment goals.
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