Yesterday's UK Budget announcement certainly gave us a lot to consider, with the abolishment of the Lifetime Allowance being the headliner.
We discuss how much attention investors should pay to the central banks of the world and what we can learn from them.
Hello and thanks for joining me for this week’s edition of the Expat Investor. My name’s Jonathon Curtis, and in this episode I’ll be discussing how much attention investors should pay to what the central banks of the world are up to, and what we can learn from them.
Nearly every country has one. The most famous of them all is the US Federal Reserve, commonly known at the Fed, with other well-known ones including the UK’s Bank of England, the EU’s European Central Bank, or ECB, and the Bank of Japan. But what are central banks and what exactly do they do?
In a nutshell, central banks are national authorities that aim to keep their country’s economy in good shape. They’re made up of a board of governors who collectively make the bank’s decisions. Each central bank operates differently, but usually they’ll control interest rates, the country’s supply of money, and aim to keep the nation’s currency stable, unemployment low and inflation in check – obviously a major concern for central banks at the moment. So as you can see they’re pretty powerful beasts. Fortunately, many operate independently of government control, including the Bank of England and ECB, so they can’t be used as a tool to curry favour with voters, and so operate for the benefit of the nation rather than the politicians. The Fed makes decisions without needing government approval but its governors are chosen by the President and need confirming by US Congress, so arguably there’s still plenty of party influence there.
For obvious reasons Central Banks don’t tend to give away what they’re going to do before they officially announce it, although individual governors can and do give their opinions in advance. Investors will also collectively form consensus views of what they expect central banks to do which will be reflected in the markets. If those consensus views turn out to be wrong though, there can be big shifts in the markets immediately following the announcement. Even when there’s no surprise though, you’ll often see some market movement following a major central bank announcement, like a new interest rate.
Most western central banks aim for an inflation rate of around 2%. Obviously inflation’s currently running well above that at the moment, with 40-year highs in many countries, so bringing it back down to the 2% target is their priority. The main tool central banks have at their disposal to deal with inflation is interest rates. By putting them up, it makes consumers and businesses less likely to borrow to spend and invest, so it’s a bit like tapping the brakes on the economy, which in turn should eventually pour cold water on inflation. It’s a fine balancing act though, as if they put up interest rates too high or too quickly it can really harm the economy and potentially push it into recession. That’s why central banks have been putting up interest rates in stages rather than in one big leap.
Specifically for investors though, how does this impact the markets? Well if interest rates and inflation are high or the economy is weak, many companies that makes up the markets could struggle as their customers buy fewer of their goods and services. Bond markets can also suffer when interest rates go up, as bond prices and interest rates have an inverse relationship so when rates rise, prices usually fall. So it’s no surprise that with all this going on right now, both stock and bond markets have been falling this year.
Given central banks control interest rates and the money supply, and aim to influence inflation and the economy, you’d expect investors to pay very close attention to what they say and do. And you’d be right. Many even hang on their every word – quite literally in some cases. There are investment algorithms that trade on the choice and frequency of words used in central bank announcements. While most investors don’t go quite to those extremes, when central banks speak, many sit up and listen. And that can move markets.
Recently leaders from a lot of the central banks got together for an annual meeting in the USA called the Jackson Hole Symposium. At the event Fed chair Jerome Powell announced he thinks the battle against inflation is far from over and further interest rate rises are needed. Although none of this was really unexpected, the 24-hours following his announcement saw the global stock market slump around 2.5%, and that wasn’t even an official announcement.
The next official Fed announcement will be on the 21st of September. The general expectation is for a third successive interest rate increase of 75-basis-points, a.k.a 0.75%, which follows similar increases in both June and July. The week before on the 15th of September the Bank of England will announce its decision on interest rates, which is widely expected to be another half a percent hike. And the week before that on the 8th of September, so in just a few days from now, the ECB is predicted to increase by another three quarters of a percent, following its rate hike in July which the first time in 11 years it had put interest rates up.
Now before you start reaching for the panic button, there a few more things you should know. Most of the time most expectations for central bank policy will already be baked into markets. So if you’re thinking about trying to jump the gun, trust me, the markets will likely already be ahead of you before the thought has even entered your mind. Markets also don’t always react like you expect them to in response to central bank actions. Forecasts about central bank decisions aren’t always right, and though we’ve no reason to believe these expectations about the coming interest rate announcements won’t turn out to be correct, central banks can throw some surprises at times.
Another point, which anyone who’s read my articles will be familiar with, is markets and the economy are not the same thing. Markets are driven by far more than economic metrics like interest rates and inflation. Yes the state of the economy certainly does have an impact on markets, but you have to realise economic figures are often backwards looking, i.e. they tell you what GDP, or inflation, or employment figures were over the past few months, and the situation could have even changed by the time the figures are released. Markets on the other hand look forwards, i.e. they reflect investors’ collective expectations of the future. What that means then is markets are often two steps ahead of the news headlines about the economy. Now markets can be wrong, and that’s when you’ll see a correction, but often they’re right.
Talking about getting things wrong, it’s also important to remember, central banks can be way off in their predictions too. Returning to the Jackson Hole symposium I mentioned earlier, last year’s meeting saw the very same Jerome Powel, chair of the Fed, with its army of economists, predict that inflation would be ‘transitory’, i.e. short-lived. In fact he used the word transitory five times. Hindsight is of course a wonderful thing, but we now know that he and the Fed were completely wrong. And it wasn’t just them. This time last year the ECB predicted inflation in 2022 would be 1.5%. And here’s what the Bank of England said at the end of 2021, “we expect inflation to rise to about 5% in the spring but then fall back. We expect interest rates will need to rise modestly to return inflation to our 2% target.” Again, just plain wrong.
So by now you might be thinking I’ve left you with more questions and answers so let me try to give you some closing thoughts. Central banks can and have had a big impact on markets, especially over the past 15 or so years, whether pumping the markets with money through the so-called quantitative easing and then starting to suck it back out again via quantitative tightening, or keeping interest rates razor thin for many years and now putting them up at record speed. The biggest driver of markets over the long term though is not central banks. It’s the companies and the earnings of those companies that ultimately drive stock market performance. As always I focus on stock markets given they’re likely to be the biggest drivers of most investors’ portfolio returns. As for bonds, government bonds or Treasuries, which make up around two-thirds of the global bond market, are driven largely by central bank policy. While interest rates go up there’s no doubt they’re a painful place to be, but eventually there will come a point when central bank stop putting up interest rates and should bring them back down again. Perhaps not to the razor thin rates of recent years, but even so whenever they do begin to cut them it’ll be a boon for bonds, plus as interest rates go up, the yields bond throw off will become more and more attractive.
So, while it’s certainly prudent to keep an eye and an ear to central banks’ words and actions, I wouldn’t base your decisions solely on what they do – you’ll likely already be a few months or more too late. And I certainly wouldn’t bet the ranch on central bank forecasts for the future. History has shown that they, as well as practically all investors, are actually pretty terrible at getting their predictions right with any consistency.
So, as always, the most important thing you can do for your long-term investment returns is stick to your long-term plan. The economy will cycle from boom to bust, and the central banks will do their best to smooth that cycle, taking markets for a ride at times. But no matter how bad things get, and trust me, things have been a lot worse than this, markets have always recovered and come good for investors in the end, no matter how much meddling the central banks have been up to.
That’s it for today. Thanks as always for tuning in and I’ll see you for the next episode.
This was recorded on the 5th of September and all information was correct at the time of recording. This podcast is for educational purposes only and is not a personal recommendation. If you’re unsure what’s right for you, you should seek advice. Past performance isn’t a guide to the future, and investments rise and fall in value so you could get back less that you invest.
Thanks for listening, goodbye.
In this series, Skybound Wealth's Head of Investments Jonathon Curtis looks at all things investing for those living outside their home country and to help you make the most of your wealth.
Jonathon cuts through the media noise to discuss topics such as: Market performance, current financial affairs, how different types of investments work, The importance of building the right portfolio, how to avoid common investing mistakes, and tell you what really matters to help you become a better investor.
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