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As 2022 started it looked likely that inflation would become a major problem that central banks and financial investors could no longer ignore.
The leading central banks came to see they had kept rates too low in the past. They had printed too much money to buy bonds.
As a precaution, the FT portfolio had 35 per cent in total in cash and short-dated index-linked Treasury bonds, with cash as the largest holding.
We took good profits on the big position we held in Nasdaq last year, the US growth companies that had led the bull market of recent years. We decided that growth companies would be hit by higher interest rates affecting longer term valuations.
The fund’s main holding in shares has shifted from technology to the broad world index to give more exposure to the sectors and regions that would benefit from the post-Covid recovery.
The world index holds more of the oil and commodity companies that held up better. Overall, the index has still fallen substantially as overall economic conditions have deteriorated. Inflation, war, supply shortages and rising interest rates have all battered shares. The world index has declined by 11 percentage points less than Nasdaq.
As inflation has risen, so in turn the leading central banks have switched from very loose to tighter policies, ending bond buying and putting up interest rates belatedly in response to the price rises.
When the leading central bankers met late last month at Sintra there were admissions that they had got inflation wrong last year. They greatly underestimated how high it would go and how long it would last. There was silence on whether expanding money and credit had anything to do with it.
They preferred to talk of the supply shocks than to remember inflation was rising before the Ukraine war, while they ignored it. They implied they could not have avoided the mistakes they made as the inflation came from events beyond their control and they pledged to do more from now to prevent inflation from embedding. The Fed made clear it would slow the economy as much as it takes to end inflation.
It is true that the Russian decision to launch a brutal invasion of Ukraine made the inflation we were already suffering worse. As Nato allies imposed sanctions on Russian trade and scrambled to replace Russian oil, gas and food in their supply chains, the prices of these crucial commodities shot up further, adding to the inflationary pressures at fuel pumps and in supermarkets.
Conversations in the markets now include the possibility of a sharp slowdown or even recession in many countries. Higher mortgage and other interest rates will slow activity at the same time as the big hit to consumer incomes comes through from high energy and food prices.
This means an imminent loss of business, with customers reducing their spend on discretionary items as bills for basics take more of their income.
Share and bond markets have fallen together, worried by the twin threats of inflation and possible recession. Market commentators are dusting down their history books to read more about the stagflation in the past century and the high interest rates it took to curb the price rises. If inflation sets in at too high a level central banks will create a recession to break it.
Today we see the strains at central banks staying hawkish to mend past errors of policy while the longer term impact of Russian violence flows through to damaged energy and food markets.
Sri Lanka shows us how these pressures can drive an emerging market economy into bankruptcy, as it has failed to meet foreign currency debt obligations. Now it is struggling to get sufficient foreign currency to buy enough fuel and food for everyone’s needs.
Other indebted countries relying on essential imports will also need help from the IMF and advanced countries. Otherwise, they will end up going through bankruptcy and debt restructuring in these stressed conditions.
The FT fund has a very small exposure to these markets. These dreadful events remind us of the higher risks in many of these places.
The US is in a stronger position than Europe, with its own gas, much of its own oil and plenty of grain from its prairies. Europe cannot easily replace all the Russian gas and oil it uses, and today faces Russia turning down the pipeline flows.
Last month, I kept cash as the largest position at 25 per cent of the fund pending some resolution of the tension between inflation and recession. It seems likely on both sides of the Atlantic that wage increases will fall short of peak levels of price rises, and that by next year inflation will be on the way down.
This also means that output will slow and central banks will come to the view that they have done enough tightening. If and when this becomes clearer, bond and share markets can start to make some upwards progress.
But we have not yet seen a full downgrade of expectations for turnover and profits for many companies. There will be pressure on business volumes and margins in many cases. We have not yet reached the point where central banks can start to hint at some end to rate rises to deal with inflation.
There remain risks in this scenario. Central banks, stung by criticisms of past mistakes, may overdo the rate rises and create recessions. People still confident of their jobs could spend more of their savings — generating more prolonged inflation if there are still too many areas of shortage.
Russia could get tougher, using its energy and food weapons against the leading countries imposing sanctions.
The best news is that much of the bad news is now widely known. Valuations of good companies and markets are more realistic. Ending bond buying by central banks was a big change, and we are closer to the slowdown that should trim general price rises and pave the way to recovery in equities.
Sir John Redwood is chief global strategist for Charles Stanley. The FT Fund is a dummy portfolio intended to demonstrate how investors can use a wide range of ETFs to gain exposure to global stock markets while keeping down the costs of investing. john.redwood@ft.com
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