Capability Brown

As inflation expectations begin to rise, how do the latest decisions by central banks in the US, UK and Europe affect your investments?

The US Federal Reserve (Fed) last raised interest rates in December 2015 when Donald Trump’s campaign to become the Republican candidate for the presidential election was only just gathering momentum. Fast-forward 12 months and the world is still assessing the result of one the most unexpected outcomes in the nation’s political history.

Yet the US economy has been holding up well throughout this period. Most recently, the growth rate for the third quarter was revised up to an annualised 3.2% from an initial estimate of 2.9%. After spending 2016 deferring rate rises owing to worries about Chinese growth and the UK’s Brexit result, the Fed clearly feels that now is the right time for an increase.

One of the main reasons for the quarter-point rise to 0.75% is the strong jobs market. Unemployment stood at 4.6% in October, the lowest rate recorded since August 2007, following a surge of new jobs over the past year. Wage growth has also started to pick up, which has helped to support consumer spending.

Gov bond yields on the rise

This positive economic assessment combined with rising inflation expectations convinced the Fed to move now and adjust rate guidance for 2017 slightly higher. We believe US rates are likely to increase by a little more than previously expected over the coming year but the Fed will not want to risk tightening monetary policy too much, too soon.

On hold… for now

In the UK, inflation could also rise above the Bank of England’s 2% target in 2017 as the weak pound translates into higher import prices. If that happens, policymakers may at last raise interest rates. But at its most recent meeting in December, the bank left them unchanged.

In the meantime, economic and political uncertainty persists. GDP growth forecasts have been lowered, and the government is set to kick-start the process of leaving the European Union by invoking Article 50 in March 2017.

“Government bonds in the US and UK have suffered sharp losses amid mounting inflation expectations, fuelled by the fiscal expansion plans of Mr Trump and the UK government.”

The ECB has announced it will extend its bond-buying programme until the end of 2017 but scale it back in April from €80bn a month to €60bn. With key elections looming across the region over the next nine months, the bank had been expected to maintain its current volume. It said it could reverse the decision to taper purchases next year if necessary.

There had been concerns that any indication that the ECB would taper purchases might unsettle financial markets, which were unmoved by the result of Italy’s referendum on constitutional reform. However, the announcement appears to have been broadly supportive for bond markets and underpinned decent gains across the region’s stock markets.

Although there are signs that conditions in the eurozone economy are improving, inflation expectations remain well below the official 2% goal. As a result, we believe rates will remain lower for longer. It is also our view that financial markets will probably push bond yields in the same direction as the US, but ECB policies should limit these moves.


Investment implications

Government bonds in the US and UK have suffered sharp losses amid mounting inflation expectations, fuelled by the fiscal expansion plans of Mr Trump and the UK government. The selling has pushed US Treasury yields to 17-month highs, while UK gilt yields were recently at their highest since June.

These recent price falls have been enough to effectively negate years of income from historically low yields. Despite the declines, we continue to see major government bonds as expensive with real yields (adjusted for inflation) remaining low or negative.

Against this reflationary backdrop, we retain our preference for corporate bonds over government debt, which is more sensitive to rises in interest rates. We also continue to see the additional income from high yield bonds as offering adequate compensation for the credit risk from this lower-quality debt.

Meanwhile, we maintain our positive outlook for global stock markets against the backdrop of expanding economic activity. In the short term, conditions could become more volatile owing to political uncertainty associated with Brexit, Mr Trump’s policy decisions and key elections across continental Europe, but valuations in markets such as Europe and Japan suggest positive returns.


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Past performance should not be taken as a guide to future performance.

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