Stock market performance over the calendar year so far to 3 April 2023 has provided us with a sea of mostly green1 – a lovely colour to see. Nearly all the major indices are in positive territory and there has been some reversal of the decline we experienced during 2022. But is this a cause for optimism? Yes, no and maybe.
Yes
Market participants are forecasting better times ahead and can see glimpses of light at the end of the tunnel. Assets are being moved out of lower risk instruments such as cash and government debt, back into equities, with the impression that many companies look undervalued based on current earnings and future growth. How quickly things change.
Wholesale gas and oil futures are substantially lower than where they were this time last year2 and inflation is still expected to drop dramatically towards the end of 2023 and into 20243.
No
Twelve-month UK CPI inflation fell from 10.5% in December to 10.1% in January but then rose to 10.4% in February4. This was 0.6 percentage points higher than expected by the Bank of England in February5. The main driver of this higher than expected inflation was food and core goods prices including clothing and footwear6.
Should inflation remain stubbornly high central banks would likely be forced to continue to increase interest rates. As determined by the Office for National Statistics the basket of goods and services used to calculate inflation changes; unexpected increases in any of the items in the basket will contribute to the headline inflation figure. If interest rates rise higher than expected, due to stubborn inflation, expect markets to respond negatively in kind.
Maybe
The market-implied interest rate forecasts that the Bank of England base rate will rise to around 4.5% this year and then fall to circa 3.25% in three years’ time7. This is part of the reason why five-year fixed rate mortgages are considerably below two year rates8. However, the UK monetary policy committee judges that risks to inflation are “skewed significantly to the upside”9. This doesn’t mean that they completely disagree with markets. It is simply that in their opinion there is a “significantly” higher likelihood of rates being higher than this in three years’ time, compared with rates being lower than this.
Global gross domestic product (GDP) has been increasing. In the US the economy is expected to grow by 0.3% in quarter one and the economic rebound in China is expected to be significant following the end of its zero-covid policies10. In isolation this is good news. However, there is also a worry that higher GDP, all else being equal, can put upward pressure on inflation. An impossible balancing act to get perfect.
Risk
What should you as an investor do with this information? Your advisor will discuss risk with you on a regular basis and this is one of the most important aspects to nail down and take seriously, as I’m sure you already do. There are many things which are not in our control, however it is essential that you have understood the level of risk you are taking and should be taking. When we assess the level of risk an investor should take, we look at three main areas.
1 Willingness to take risk.
We use a psychometric questionnaire to establish willingness to take risk. This is your own personal attitude to risk and includes your previous experiences of taking risk with your money. The answers are used as a discussion tool to help us comprehensively understand some of your preferences when it comes to investing.
It is worth being aware that our individual willingness to take risk will change over time. The timing of completing the questionnaire can lead to profoundly different outcomes compared to our long-term view. It is not infrequently the case that a questionnaire completed just before retirement, or during a challenging economic environment, can make us place too much emphasis on the present and cause us to be temporarily risk-averse. At times like this an advisor who understands you will discuss whether or not strategy changes should be made and whether your change in willingness to take risk is truly reflective of your longer term views.
2 Need to take risk.
Return and risk tend to move in tandem, especially over longer time horizons. The higher the risk the higher the potential return but also the higher the potential falls.
After we have mutually agreed upon the financial objectives an individual wants to realise, we can then assess whether these are achievable and what level of return (risk), if any, is needed to realise their goals. It can in theory be the case that an individual needs to take no risk to achieve their objective. Take the outlier example of a 75 year old with £1million in cash but an objective of only £15,000 per year in withdrawals. In this case the client’s need to take risk might be zero11 i.e. they might be able to keep all their cash spread across a lot of banks, not take any capital risk, and not have to talk to someone like me regularly!
3 Capacity to take risk.
Capacity to take risk is a financial calculation and it looks at whether and to what extent someone can absorb falls in the value of their investment and maintain their standard of living and/or objectives. It differs from need to take risk because it only looks at what theoretical loss could be incurred. Each risk level comes with incremental assumed lower/higher gains and lower/higher losses. To use an outlier example again to illustrate – if someone needs £20,000 in one years’ time to pay off their mortgage and only has £20,000 in cash, you could surmise that they have no capacity to take risk because they are unable to absorb any falls in the value of their investment.
In summary there are no easy answers but being aware of the true risk position of the client is key. The support of an adviser can be invaluable in helping achieve the right outcomes. Market and economic volatility cannot be predicted however effective planning for the long term can help construct a robust strategy that is better able to withstand exogenous shocks.
This article represents the understanding of Taylormade Financial Planning LLP at the current time based on available evidence. The article is for information purposes only.
Article written on behalf of the Investment Committee
References
1 https://markets.businessinsider.com/indices
2 https://tradingeconomics.com/
3 to 6 Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 22 March 2023
7 Monetary Policy Report February 2023
8 https://www.forbes.com/uk/advisor/mortgages/mortgage-rates-03-04-23/
9 Monetary Policy Report February 2023
10 Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 22 March 2023
11 This is for illustration purposes only and is not guaranteed. The example assumes an interest rate of 2% per year, no other assets and income sources and life expectancy until age 100.