Rates of inflation rose further in the second quarter and continued to take hold in a broadening range of goods and services. Although certain to rise even more in the months ahead, we are confident that inflation will ease in 2023. The key questions are what level inflation will fall to, especially if a wage price spiral has become established, and what the cost will be in economic terms, due to the cost-of-living squeeze and the degree to which interest rates need to be raised to bring inflation under control. Will stagflation morph into recession? The tightrope on which central banks are treading as they navigate a path between the perils of inflation and recession grows ever narrower.
It was another wretched quarter for investors in bond markets as accelerating inflation caused bond yields to rise again and prices to fall further. Paradoxically, index-linked gilts, in which both interest payments and the final repayment of capital are linked to inflation, performed even worse than conventional UK gilts, whilst corporate bonds were undermined by fears of recession. Although high rates of inflation are likely to continue to act as a headwind to bond markets, 10-year gilt yields have risen significantly (from 0.1% in August 2020 to 2.2% at the end of June 2022). There is now at least some scope for yields to fall, and prices therefore to rise, if the economic slowdown deteriorates into recession.
Global stock market indices fell sharply in the second quarter, pincered between rising bond yields and mounting fears of recession. The UK and Japanese markets proved the most resilient, the former supported by its heavy weightings in energy and other multinational companies which benefit from a weak pound. Although bond yields could rise further, the outlook for stock markets probably now depends on the severity of the economic slowdown and its impact on corporate profits. In portfolios which are composed of actively managed funds, we are emphasising exposure to high quality companies with strong balance sheets and robust revenues.