Markets & Investment Outlook Bond market volatility, Is gold a good inflationary hedge?, The dangers of crypto currencies

Markets & Investment Outlook

In this section we look at a few topical areas of financial markets. In the first article we look at bond market volatility, which has seen steep falls in bond prices and losses for bondholders. We also look at whether gold is an effective hedge against inflation. Finally, we review the dangers of cryptocurrencies in the light of the current phase of ‘ risk-off’ in markets.

Bond market volatility

The recent turmoil in the bond markets is unsurprising although dramatic. The Federal Reserve Bank (the Fed), the US centralbank,hasremovedtheextraliquidity it was pumping into the bond market. In addition, the Fed has started tightening the benchmark Fed Funds interest rate 0.5% at a time and will continue to do so until inflation appears to be under control. In other government bond markets, inflation relative to bonds implies significant, albeit very late, tightening. For example, UK inflation in the second half of 2022 is expected to exceed 10% while UK interest rates languish at 1%, and in the Eurozone, inflation is circa 8% while the ECB interest rates are 0%.

So why do we say the bond market turmoil isunsurprising? Inflationwasthoughttobe beaten as a result of the world’ s economic policies, notably monetarism. However, since the Covid outbreak and, to an extent, over the decade and a half since the financial crisis, monetary policy has been extremely loose. This is due to the printing of money via Quantitative Easing, bond buying by central banks and ultra-low interest rates in the main markets of the developed world (US, Japan and the Eurozone). Attimestheinterestratesinthe EurozoneandJapanhavebeennegative. If youprintenoughmoneyandpumpliquidity into the financial system, you will get inflation. Coupled with supply shocks coming out of China, high energy prices as a result of the Russo-Ukraine war and tight labour markets due to low birth rates, the result is explosive inflation. The yawning gap between key central bank lending rates, inflation and government bond yields can only result in one outcome – falling bond prices and rising bond yields (see table below).

Governments in the developed world have been working to get inflation back into the financialsystemtoerodethefuturevalueof the bond payments they have to make. However, this is playing with fire in monetary terms because once inflation becomes entrenched in financial systems it can be very difficult to get shot of it.

Global Bond yields, Inflation and Interest Rates

(Source: Bloomberg/Economist/4 Shires)

Theglobalbondmarkets the losses that have occu bond indices. havefallensignificantly rred in local currency t over erms thepastyear. (i.e. unhedge T d) hetable for the belowshows major global

(Source:Bloomberg)

What markets are really concerned about is where bond yields might peak from here. There is resistance around 3.2% on the key global benchmark bond, the US 10 year Treasury. It approached this level recently and then retreated. We expect this level to be breached at some point this year.

In the UK, given the enormous disparity between inflation and interest rates, it is much harder to gauge the destination of 10 year bond yields. Until bond yields exceed inflation,itishardtoknowwhentheymight peak. Economists are divided about the destination of rates. Some are saying a recession will come sooner than elsewhere in the world, thereby eviscerating the need to raise rates much. However, other economists are saying that interest rates must rise meaningfully to tame inflation. I suspect a level nearer 4% to 5% is a level that will choke off any inflation. The effect on the economy may be severe, but the wealth of the nation could decline a lot more if sterling depreciates further. This is what Bank of America are currently predicting,andtheyestimatetheGBP/USD exchangeratecouldfallto$1.10inthenext 12 months from its current $1.25 level. Higher interest rates could prevent some of that drop, but many believe economic performance must improve substantially first, which may be difficult if Britain enters a trade war with the EU over the Northern Ireland protocol.

Whatiscertainisthatbondmarketvolatility, notably falling prices and rising yields, will continueuntilthefinancialmarketsfeelthat they have confidence in central banks and governments ’ desires to tame inflation.

Is gold a good inflationary hedge?

Inflation is now a primary concern for investors. The huge monetary stimulus followingthepandemiccreatedvastdemand for goods and services with limited supply. Furthermore, the crisis in Ukraine has only heightened the inflation fears with the price of oilhitting14yearhighs,whilstnickeland wheat also hit record highs. So where can investorsgetprotectionfrominflation?Gold isaprovenlong-termhedgeagainstinflation but its performance in the short term is less convincing.

Fromthe1970stotheearly1980stherewas a strong correlation between high inflation and strong gold returns. According to a study by the World Gold Council, since 1971,goldhasreturned15%perannumon averagewheninflationhasbeenhigherthan 3%, compared to just over 6% per annum when inflation is under 3%.

However,if welookatthedatamoreclosely, onecanobservethat,althoughgoldappears to offer a reasonable hedge over the long term, its credentials in this aspect are less clearovershortertimeperiods.Asshownin the chart above, the relationship between gold and inflation has been weaker over the last couple of decades than at any other point. The argument for this weaker relationship is that we have been through a periodof lowinflation.Nowthatinflationis rising(dramatically)forthefirsttimeinover a decade, the expectation is that the gold price will increase. However, it is important tolookatwhatdrivesthegoldprice.Asgold does not pay an income, have a maturity

date and carries sentimental value, it is difficult to value using tradition financial models. It is essentially worth what people are willing to pay for it. Times of fear lead torationalorirrationaldecisionstoinvestin gold due its store of value. Inflation is definitely a fear for many investors however there are more assets than ever to compete as an inflation protector including multiple inflation linked bonds. Gold also no income to pay to clients.

Gold price chart (1970 to 2022)

If it is more than a short-lived event, an inflation-protected portfolio should include gold for the benefits it brings. In the long term, gold serves as a strong strategic component in many portfolios, not only for diversificationbenefitsbutalsoforitsreturns. The low correlation that gold has with equitiesinparticularishugelybeneficialand could be worth its weight in gold. However, when there is a return on cash from higher deposit rates, gold can underperform. Finally,thestrongUSdollarisrestrainingthe gold price from appreciating.

The Dangers of Cryptocurrency

Cryptocurrencies have become a major financial asset in the last few years, particularly over the last 24 months. They have essentially become a new asset class as an alternative to more traditional forms of investing.Sopopularhavethelikesof Bitcoin, Ethereum and Ripple become that, accordingtoastudybyNerdWallet,almosta third (31%) of 18- to 24-year-olds would ratherinvestincryptocurrencythansaveinto a workplace or personal pension! In many cases this is because of the perceived risks involved in investing in pensions, with over a quarter (26%) of young adults saying that they were reluctant to save into a pension becausetheyfeltitwastoorisky.However,the risks involved in investing in this asset classes arefarmoreapparentthanotherclassesand are discussed below.

Even someone with little knowledge of cryptocurrencies will likely be aware of how volatile they can be. Huge price swings have become part and parcel of the cryptocurrency landscape. Between July and October 2021 alone, Bitcoin traded both below £22,000 and above £48,000. These boom-and-bustperiodscanmakeitveryhard to predict the long-term price performance of cryptocurrencies.Andwhilethatistrueof anyinvestment,thescaleof thevolatilityseen in the cryptocurrency sector and the tendency for prices to move for dubious reasons – as a result of tweets posted by Tesla ’ s Elon Musk, for example – means you must keep in mind how sharp and sudden losses in crypto value can be. When buying cryptocurrencies, you bear more of the responsibility for the storage of your assets than you would with other investments. You will store your cryptocurrencies in a digital crypto wallet, encrypted with a private key. Since these private keys are extremely long, you will also be given a 12 word phrase knownasaseedphrase,whichcanbeusedto recover funds and access your wallet. If you forgetthisphrase,orloseyourcopyof it,your cryptocurrency assets will very likely be lost forever. This means investing in cryptocurrencies can leave you at the mercy of human error, which is no small thing.

The aspects of cryptocurrency storage that make them prone to human error are also puts make them in danger of hacking and other security breaches. In August 2021, for example, $600 million (£433 million) in cryptoassetswerestolenwhentheBlockchain sitePolyNetworkwashacked.Digitalcrypto wallets,suchasmobileanddesktopapps,are also called ‘hot wallets ’ . This means that, while they are easily accessible as they are stored online and are heavily encrypted, the internet connection required means they are not 100% safe from hackers.

At present, cryptocurrencies are largely unregulated and decentralised (although if global governments have their way, this may change in the future). In fact, for many, that is their biggest appeal. Yet this also leaves investorswithoutregulatoryprotectioninthe case of theft and hacking, and at risk of encounteringcryptocurrencyscammers.Due tothis,andtheextremepriceswingspossible in crypto, the Financial Conduct Authority (FCA)evengoesasfarassayingthatinvestors should be prepared to lose their entire investment.

We view cryptocurrencies as uninvestable as wearenotsurewhatwearebuying,wecan ’t trust where they are stored and increased regulation is likely to remove investors, some of whom are criminals, from the market.

Investment Outlook

Bond and Stock markets in the first half of theyearhavecontinuedtobeinatugof war between whether growth or value investments will be more attractive. Global technologyshareshavebeenunderpressure, although we still believe that further losses are highly likely as volumes are still modest relative to a financial capitulation of confidence that is usually seen at the end of what has been a frothy and enormous bull market.

However, value shares and those with some measure of inflation protection are performingbetterandarelikelytocontinue to do so. Many of these stocks are found in theUKandthishashelpedtomaketheUK one of the best performing markets in the world this year.

As mentioned above, we expect bonds to perform poorly in the second half of this year, and possibly beyond. Inflation rates are too high for current interest rate levels and central banks are playing catch up to realityhavingbeensurprisedbythestrength of inflation.

Withregardtocurrencies,wefavourtheUS dollar as likely to remain a safe haven for investors cash, and it is beginning to offer increasing yields. We expect sterling to remain weak, with the Euro somewhere in between GBP and USD.

Risinginterestratesandwagescoupledwith a supply shock are not a recipe for benign asset markets, and we remain cautious for global growth prospects in 2022. However, proactive asset management is critical in these times and at 4 Shires we remain cognisant of the risks to client wealth from the current situation.

JLS/DIS/HAH – 2/6/22

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n r t u e R d t e h i g e W e i m T 50.00%

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UK IMI 6.92% 33.37% 8.72% 10.08% 18.84% 46.96% 36.01% 42.00% 58.92%