Current Financial and Economic Outlook with Lothar Mentel

Q: How is the current higher levels of inflation affecting financial markets?

A: Lothar Mentel: “Certainly with all the negative sentiment you wouldn’t have thought that there could be any positive returns this year, yet, if you look at multi-asset portfolios their returns have been positive. Okay, the higher the equity exposure the higher the returns are overall, but considering that everybody has been talking about a cost-of-living crisis, impending recession etc., it’s actually quite positive.

So why is that? Well, we are in an environment which is classically cyclical. We’ve come out of the pandemic with some overstimulation from both governments and the central banks, and you can’t criticise them too much for it because nobody knew how much stimulus was enough and how much would have been too little, and as everybody wanted to catch up with all the things that they had missed out on, the consequence for the global economy is that it overheated and we got high inflation.

High inflation has had to be tackled by central banks and they do so by increasing interest rates. Because we haven’t had any meaningful interest rates or yields for a good 12 years, everyone thought by increasing interest rates they’d kill the economy off in an instant. The big surprise this year however has been just how resilient the global economy has been in light of us returning to yields and interest rates that we haven’t had for more than a decade. That’s the big story of the year. Now, that doesn’t mean to say that it’s all good but it does give the markets something to hang their hats on, particularly because inflation is now coming down quite considerably. Inflation is still too high compared to the 2% target, but it’s falling so quickly that if it continues to fall at this rate, we’re at the 2% – 4% level pretty quickly. The US are already there.

If we were to annualise the monthly rate of inflation at the moment, then, from a UK perspective, we’re moving to the target quickly, albeit energy prices are quite volatile at present so they may be ticking up at the moment. There is less pressure on the central banks now to raise rates further although that doesn’t help with the current cost-of-living crisis or the effect on mortgages. Interestingly, the bond markets have kind of taken over the job from the central banks insofar as hiking yield rates and that’s now taking on a life of its own. We’ve seen another uptick in the yields from US 10-year treasury stock which has caught a lot of analysts by surprise.

In a nutshell, we are in an environment which is not entirely bad, but the longer the high yield environment lasts, the worse it gets for companies. Just like ordinary people with low fixed interest rate mortgages are having to move to much higher rates when their deal term comes to an end, the same applies for companies with debt finance. Whilst it’s all gone quite well so far if this situation lasts another one or two years at these levels, you can expect to see more company debt defaults. We know that debt cycles can sometimes kick off recessions.

At the moment, economic and financial indicators all point towards a ‘soft landing’ rather than recession, which is what everybody really wants to see. There are still quite a few risks out there that might derail the current direction of travel though”.

Q: Will the current higher level of bond yields have a greater positive or negative impact on more cautious portfolios i.e., those with a higher exposure to fixed income securities, government gilts, corporate bond debt?

A: Lothar Mentel: “For much of the last 12 years we’ve had super low yields, as low as 0.5% on 10-year bonds. With interest rates and inflation rising rapidly last year, a significant and painful correction occurred in existing bond values to level up on rising yields. Now we’re at 5% – 8% all of a sudden within a portfolio context, fund managers can work with that again.

What investors mustn’t forget, whilst it looks tempting to move into cash deposit accounts at the moment and without the investment risk, there is one certainty which we know for absolute sure, which is that cash and very low risk bonds have hardly ever, if ever, outperformed long-term inflation. So, it might be tempting at the moment, but if you are then stuck in a term deposit cash account and the markets all of a sudden see the light at the end of the tunnel and take off, then more often than not, investors will have missed the growth opportunity”.

Q: In the last 12 months cautious assets haven’t actually reacted to volatile situations as we would have expected them to. What has caused that to be the case?

A: Lothar Mentel: “We need to differentiate two timeframes here. For those people who have been invested for quite a long time in their balanced portfolios, they would have seen much higher returns from their bond/fixed income exposure over the last seven or ten years, than we would normally expect and that has now corrected as yields have gone up and values of bonds have come down.

My heart goes out to all those who had gone into those lifestyling portfolios, mainly linked to pension plans, where all of a sudden, just before their retirement, their funds switched entirely to fixed income securities and they were stuck 100% in very long maturity gilts and lost 20% – 25% of their portfolio value. Usually, in my experience, those clients were not those who were advised by IFAs, they were usually in the sort of standard portfolios within their company pension schemes. There was a lot of damage there. It doesn’t mean one shouldn’t touch bonds ever again, it needed that reset to get back to the more normal yield levels. Now that we have yields of between 5% and 8%, as I said, whenever the yields tick higher, there is an opportunity to add them to investment portfolios. If you can get that yield level for the next 10 years, guess what you’re going to get for the next 10 years”.

Q: What is your response to investors who quite rightly say their investment performance over the last three years or so has been underwhelming and moving to cash may be a good alternative?

A: Lothar Mentel: “Investors currently look at their three and five year returns and may well consider performance as being a bit pedestrian compared to inflation and may think that I’m not sure I’m actually getting the best here. Actually, if you’re looking over the medium to longer term, well diversified investments of stocks and shares and fixed income securities have significantly outperformed inflation. So just before we get into some of those myths that are circulating out there, usually when you have this sort of environment of returns looking pretty pedestrian, that tends to be the beginning of the next cycle. So, yes, as you’re looking back, of course, it doesn’t look that great but then if you’re not in it, you can’t win it, i.e., you will potentially miss the next upswing and that would be a real shame for the long-term returns”.

I’m pleased that individuals’ rainy-day cash is finally getting some sort of return, although on the downside at the moment the cash returns are just about meeting the rate of inflation, so you’re not really increasing your purchasing power.

As we said earlier on, the one certainty in capital markets is that inflation always outperforms cash, so it’s not a long-term strategy really if you want to grow your money or your nest egg, for say a better retirement.

If you’re thinking, well I’ll just take those nice returns at the moment, while equity markets or general investment portfolios are a bit pedestrian, and once the financial markets recover, I’ll just go back into it, unfortunately and particularly with retail investors it doesn’t happen and work like that. When you should invest or stay invested is probably when the clouds are particularly dark on the horizon. Often there are times when we hear that corporate earnings are falling, that margins are falling and it all sounds quite negative but you then see equity markets going up. Why is that? It doesn’t make sense as companies are earning less. Well, it’s because the analysts can see that the cycle is turning and their earnings forecasts for next year are quite positive, which at the moment is what’s holding markets together”.

Q: What are your thoughts about the current geopolitical issues and how they are impacting investment portfolios?

A: Lothar Mentel: “First and foremost, as a human being there’s no words that can describe the pain we feel about violence perpetrated on innocent people.

Unfortunately, or fortunately, whichever way you want to look at it, capital markets don’t have a moral compass. They react to things that change the economic parameters of the globe and therefore there was a much stronger reaction when Putin invaded Ukraine because it was immediately clear that the cheap gas that had been propelling, in particular the German economy for the previous decade, was probably not going to continue. Therefore, the parameters had changed. At the moment, in the Middle East, while that is absolutely disastrous from a humanitarian point of view, it hasn’t actually had that much of an impact on the economic parameters.

So just to make the point, in the previous week the oil price had fallen by 12% and you would have thought that with the surprise attack on Israel being in the Middle East, the oil price will immediately shoot up again and go through the hundred dollars. Well, it didn’t. It went up 4% or 5%, then came back down again. At the moment it’s undecided. It is because at the moment that conflict is contained and there seems to be quite a concerted effort – and I’m not a political expert and don’t formally comment on it, but it is notable how much effort seems to be going into just trying to prevent this conflict from proliferating across the region. So, if we were to see Israel and Iran getting into hostilities, well then that would lead to a change of parameters.

Some of our older clients will remember the Yom Kippur War in 1973 and the oil embargo and the oil crisis which ensued which led to an increase in the oil price. We have to recognise that the oil supply these days is far more globally diversified than it was back in the seventies, so even though it would still not be great if hostilities proliferated, it would not be the same as the oil shock of the 1970s”.

Q: Globally we’ve seen a big jump in interest rates to combat inflation, – are these increases set to continue, stabilize or start to fall?

A: Lothar Mentel: “That’s a very good question because it’s a big debate at the moment as well. Whenever something has surprisingly moved higher, then there will be lots of commentators who say, you know what, it’s not going to go down again it’s going to stay as high as it is.

Well, we had the same with the oil price and it came down again and so interest rates at the moment seem to be on a pause and central banks don’t have to increase interest rates any higher at the moment because inflation is coming down. The bond markets are restricting the credit markets and therefore growth is somewhat subdued and other inflation drivers are being driven down.

Central banks don’t increase interest rates just for the fun of it, they do it to fight inflation. So, if inflation normalises, the reason to have higher interest rates goes away and there’s an expectation that they will come down again”.

Q: Has the full effects of interest rate rises been felt by the public yet?

A: Lothar Mentel: “There are two points on that. The first one is, if you look at the latest figures from the Bank of England, the public overall have received more in terms of interest from their cash than they have, in aggregate, paid out in higher mortgage payments. So that’s in aggregate, but obviously who’s received the money on the cash, it’s the older generation of society that haven’t got a mortgage, whereas younger people have not been able to get onto the housing ladder either because they’ve not been able to save or the cost of borrowing is now too high. So, it’s not necessarily good for society overall that we have that discrepancy”.

Thank you to Lothar for answering our questions.