Has the world fundamentally changed?

As inflation and interest rates rise, investors will need to adjust to a new normal, but certain types of company can thrive in all conditions.

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

The Global Financial Crisis ushered in an era of low interest rates, which brought about real strength in asset prices. However, the easy money era came to an abrupt halt in 2022 as higher inflation forced central banks to raise rates quickly. This has proved a tough backdrop for financial markets. As investors make their investment decisions, they will need to ask: is the world a different place today?

The past decade has been defined as ‘the great moderation’, a period of low interest rates, low inflation and rising asset prices. Central banks and governments have supported growth, and money has been almost ‘free’ enabling businesses and consumers to borrow at extremely low cost.

However, this period is at an end. Supply chain disruption caused by the pandemic started to push up inflation in late 2021.1 Mounting geopolitical tensions and in particular, the war in Ukraine, have driven commodity prices higher,2 creating more inflationary pressure. Prices have been rising at 8-10% across much of the developed world for the past six months.3

Central banks have been forced to take action, raising rates across the board. This has put an end to the ‘free money’ era. The question for investors is what happens when this current crisis is over and there is a return to a more normalised inflationary environment.

A different era

Central banks predict that inflation will start to moderate over the next six months4 as supply chain pressures resolve and the worst effects of commodity price rises come out of the figures. However, the Bank of England believes that inflation will average at above 5% for 2023 and will remain structurally higher, with a similar picture in the US and Europe.5

This means that there is unlikely to be a reversion to the ultra-low interest rate environment for the foreseeable future. It is possible that the Federal Reserve and other central banks will keep rates higher even when inflation appears to have peaked to prevent any resurgence. While rate rises may be curbed by weakening economic growth, a return to zero interest rates looks implausible. This affects the type of assets that do well.

Geopolitical tensions

A new geopolitical world order is coming more clearly into view. COVID-19 and Russia’s invasion of Ukraine have accelerated fragmentation and the emergence of competing geopolitical blocs. Relations between China and the US were already worsening and the Ukraine crisis has deepened the fissure. The BlackRock Geopolitical Risk Indicator is above its historic average, meaning investors remain attentive to geopolitical risks.6

This creates a different type of environment, one where countries no longer trade freely and there is increasing nationalism on areas such as technology or green energy expertise. The CHIPS and Science Act, passed in the US in August 2022, aims to improve US semiconductor research and manufacturing.7 Outside of this Act, the US will simultaneously focus on cutting off support for Chinese chip manufacturers and designers.8 It is symptomatic of a broader fracturing of China/US trading relationships and an end to any sharing of intellectual property.

Sustainable investment

The climate has become an emergency – from global warming, to biodiversity loss, to water scarcity. There are now real world effects for companies that do not manage environmental risks effectively. At the same time, there are significant opportunities for companies that appear to have the solutions to these crises. Incorporating sustainability analysis into investment decision-making is therefore becoming more important.

Increasingly, companies that score badly on ESG (environmental, social and governance) metrics are likely to face growing regulatory problems and greater barriers to doing business. Around 90% of the world’s GDP is generated by countries whose governments have set a net zero targets. Policymakers around the world are enacting legislation to encourage progress.9

Investment considerations

This is a new era and investors will need to adjust. The end of free money makes it a more difficult environment for fast-growing companies that require a lot of capital, or companies with high levels of debt. It tends to favour cash generative companies or those paying a dividend. This may alter the balance in stock markets after a period when technology stocks have done very well.

However, there are certain universal truths on investing that won’t change: good companies with strong balance sheets, run by capable management teams with a focus on sustainable growth will thrive in the longer-term. This is the type of company the BlackRock investment trust managers are seeking out, with the aim of delivering capital growth and income for investors in the year ahead.