Is inflation beaten? The impact on stocks and bonds explained

Inflation is back at target in the UK, at 2%, after its recent peak of 11.1% in October 2022. To bring it down, the Bank of England pushed interest rates up from 0.1% to 5.25%, then held them there for around a year before cutting rates for the first time in four years last week to 5%.  

The Bank of England’s Monetary Policy Committee voted five-to-four to cut rates, showing that the decision was far from unanimous, and that the inflation battle has not yet been won. 

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The Bank said that CPI inflation is expected to increase to around 2.75% in the second half of this year, as declines in energy prices last year fall out of the annual comparison. 

Part of the battle is bringing down service price inflation, which currently sits at 5.7% in June, as well as wage growth, which is at 5.6% in the three months to May.  

Nevertheless, the Bank of England is optimistic that inflation is close to being defeated. It says: “Domestic inflationary persistence is expected to fade away over the next few years, owing to the restrictive stance of monetary policy.” 

But how will this impact stock and bond markets, and is inflation really under control? 

Can stocks keep up their strong run? 

Stocks are wobbling due to signs that the US economy could be slowing and there may be a recession coming. Coupled with disappointing earnings from many large technology firms, investors are taking the opportunity to trouser profits.  

But despite a recent drop in share prices, which saw the S&P 500 fall about 5% in a week, the outlook for shares in a lower-rate, low inflation environment is generally considered to be positive.  

Bank of America says this “pullback” is not unusual and calculates that 5%-plus pullbacks have occurred three times per year, on average, since the 1930s. 

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Both falling inflation and interest rates should stimulate economic growth, which is good news for company profits, and valuations of equities tend to rise when rates fall, as returns on cash-like investments are squeezed, which makes the stock market more attractive. 

Invesco thinks that markets are overly worried about a recession in the US as it believes the US jobs market is in relatively good shape and employers appear reluctant to cut staff. 

Overall, it says there are plenty of reasons to be positive on equities, including lower valuations after this market correction and coming interest rate cuts in America. 

Kristina Hooper, chief global market strategist at Invesco, adds: “I wouldn’t be surprised to experience a volatile and challenging market environment in coming weeks. However, I still worry that the biggest mistake long-term investors could make is getting spooked and moving out of markets.”

Hooper says that she has seen this emotional investor reaction occur in significant sell-offs over the years, including the global financial crisis, and it is perhaps the most damaging decision investors can make.  

“Rather, I am optimistic this sell-off could represent an opportunity for those patient investors with a significant overweighting to cash to consider reducing that exposure,” she said.  

Are bonds finally back? 

Bonds are finally proving their worth as a diversifier, and also providing investors with an excellent income stream.  

Bond prices are very sensitive to interest rates, with rising interest rates generally causing bonds to fall in value so that yields come in line with market rates. That is why bonds fell so much in 2022 – investors had to reprice existing bonds because new bonds were being issued with higher interest rates. On the other hand, falling interest rates have the opposite effect, with bonds increasing in value, reflecting lower yields. 

Recently, bond prices have been rising due to worries that economies are slowing, and central banks will have to act by cutting interest rates. Now that inflation is back at target, this gives them more freedom to do so, as it is less likely that they will impact inflation.  

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Chris Iggo, chief investment officer at AXA Investment Management, says the recent UK interest rate cut is good news for gilts.  

“We think there is room for gilt yields to fall, which is also supportive for UK corporate bonds, particularly at the short end of the curve. The one-to-five-year sterling corporate bond index has delivered a total return of close to 3% this year to the end of July, and over 9% compared to a year ago,” he said.  

Fidelity International, the fund manager, says short-dated corporate bonds are a fixed-income sweet spot. This is because the short end of the curve is influenced more by monetary policy than the longer end of the curve. In a cutting cycle, this means there can be a larger positive interest rate impact. 

“With rate cuts now under way, we continue to like high-quality corporate bonds, particularly given the additional yield advantage over government bonds. Within the investment-grade credit landscape, we particularly like the short-dated (sub five-year) part of the curve, which offers attractive risk-adjusted returns,” the fund manager said.  

Gold set to shine? 

One beneficiary of falling interest rates could be gold, and companies that mine the precious metal. 

Ian Williams, a fund manager at Charteris who manages gold and fixed-income portfolios, says that the outlook for the commodity as well as the gold-mining sector, is looking very positive. 

His view is that gold is likely to rise to above $3,000 (£2,361), from around $2,400 today, and possibly more over the next six to 12 months.   

Williams says the main drivers are that central banks continue to be solid buyers as they diversify their reserves away from the dollar, US interest rates are set to fall which is generally positive for gold, and gold miners are likely to benefit, particularly as their operations become increasingly profitable as gold prices rise. 

He also says that gold provides a safe haven against rising global debt levels and geopolitical risks. 

Is inflation really beaten? 

One fund group that does not agree with the Bank of England is Ruffer, which manages the wealth preservation focused Ruffer Investment Company Ord (LSE:RICA). Its view is that we are in a new world of higher and more volatile inflation.  

It argues that part of the problem is that governments believe in a “magic money tree”, and growing government debt will create economic problems. Therefore, government bonds are not the safe haven they once were. 

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Its solution is to buy inflation-linked bonds and short-dated bonds, and avoid most equities. Indeed, its flagship investment trust has about one-third in short-dated bonds and about 20% in inflation-linked bonds. It prefers UK equities, at 11% of the portfolio, which are cheaper than global peers.  

Ruffer says: “We believe the bull market in equities is running out of positive surprises and that is a dangerous set-up given starting valuations. There is no doubt that there was a wall of worry to be climbed since 2022 when recession and inflation fears loomed large.  

“Since then, markets have enjoyed almost 18 months of positive economic surprises. In the last couple of months, the data has started to come in a little softer, versus raised expectations, and there are signs of the economy slowing, as the fiscal impulse of 2023 wears off.”