As Storm Eunice ravages Great Britain, American investors are paradoxically finding shelter in the calmer British stock market. The UK stock market is not usually a cause for excitement; however, it is this very feature that is attracting foreign investors. The global stock markets, especially American in this case, are particularly volatile with inflation scares. As a result, the central banks are predicted to adopt quantitative tightening, as well as potential interest rate spikes. London Stock Exchange’s (LSE) tendency towards lower risk stock is currently attractive to nervous, inflation-sensitive American investors.
The largest component driving the markets today is the rising level of inflation. Although inflation can be interpreted as positive or negative indications for the economy, currently investors are cautious about surging inflation. The impact of rising inflation on investors depends on whether the causes of inflation lend themselves to a transitory or long-term explanation. If it is long-term, then it is likely that central banks will implement more drastic monetary policies, which have both expected and real consequences on the market.
The current level of inflation in the UK is 5.5% which is clearly above the 2% target set by the Government. In response, the Bank rate doubled to 0.5% in January 2022. The rise in inflation is partly a positive indication since it has been driven by rising demand as coronavirus restrictions have been reduced. The employment rate has also increased so it could be said that the inflationary pressures were inevitable and merely a natural consequence of growth. Tangentially, supply constraints have led to increased commodity prices. In the US, inflation hit 7% which is relatively high and of concern to investors there. However, it seems likely that the increase is being driven by transient post-pandemic demand. It is expected to reach 7% by spring 2022 in the UK and then fall subsequently. In all, inflation appears to be a transitory issue that investors can observe for the long term.
Although the general welfare of the economy is of interest to investors, inflation has a more quantifiable impact on traders’ decisions. When inflation is elevated, stocks tend to present with higher equity market volatility and risk premium. This is correlated with lower returns on equities. Since investors aim to increase long-term purchasing power, they must work harder to maintain their investment returns concerning the rate of inflation to increase real purchasing power. Furthermore, the lack of predictability of inflation increases the required long-run return on stocks to compensate for higher risk. Since inflation typically reduces expectations of earnings growth, there is downward pressure on stock prices.
In response to rising inflation, central banks are considering contractionary monetary policies. This is the reverse of covid response measures when central banks cut interest rates globally and launched asset-purchase schemes that were reminiscent of those used after the 2008 financial crisis. The Bank of England said it would begin reducing the 895 billion GBP stock of debt it has bought by ceasing reinvestments of government bonds it holds. When interest rates rise another further 0.5%, the bank will consider selling gilts. This direction towards quantitative tightening (decreasing the amount of liquidity in the economy) is likely to be widespread in global central banks. For example, the Federal Reserve is predicted to start quantitative tightening later this year and is expected to raise its interest rate. Central banks feel that the surge in employment and growth will give them some latitude to withdraw some of the copious stimuli they provided in the pandemic.
Some believe that the market is relatively complacent towards quantitative easing as opposed to its sensitivity to interest rates. Longer-dated debts, which were greatly benefited by quantitative easing programmes, have sold off at a slower rate than short-dated bonds, which track interest rate expectations. This focus on interest rate expectations and subsequently less on longer-term bonds is advantageous to LSE. As mentioned, the UK stock portfolio is more likely to consist of lower risk long-term assets and thus American investors are finding comfort in the smaller risk. There is a heavy concentration of unpopular investments such as banks, miners, and energy products, from HSBC to oil major BP. Unlike tech stocks, they usually win in rising interest rate situations. The former is far more prevalent in the FTSE 100 index.
In addition, this practice of trimming portfolios presents concerns for investors due to falling liquidity. As central bank balance sheets shrink, there is less money in the market and less demand for bonds. Investors themselves are also less likely to be compensated due to the higher risks and volatility.
Usually, when inflation rises suddenly, the uncertainty leads to lower earnings forecasts and equity prices. However, in the UK, stocks have outperformed global equities this year, which highlights that investors are looking to exit higher-growth businesses. British stocks are more than 9% points ahead of the MTSCI World index, which has fallen by 6% over the same period. (Figure 1). If this trend continues for the rest of the year, then this will be the first time since 2011 that UK equities have outperformed the rest of the world. Following these trends, J.P. Morgan last month upgraded the UK to ‘overweight’, thereby promoting its weighting in the investment portfolios of its clients.
Although the transfer of US investors to the British stock market provides a short-term boost, it is only indicative of the slow pace of the British stock market overall and how it is underperforming compared to its counterparts. Foreign investors will only remain if they are cautious, which will come to an end once this period of excess uncertainty passes, and traders acclimatise. The British stock markets should take this opportunity to re-examine its focuses before they are left bereft in the next season.
Written by: Hannah Duale
Sector Head: Sophia Li