In an uncertain world it pays to have some balance in your portfolio.

Much has been made of the positive role of central banks in the Great Financial Crisis of 2008/9, but now is arguably as challenging a time for monetary policy makers around the globe. News of divided opinions at recent Bank of England monetary policy committee meeting is not a surprise. If it is any comfort to them, their counterparts at the US Federal Reserve and the European Central Bank face similar dilemmas.

In a crisis it is often clear what needs to be done – though it can take courage to do it. But moments like this are clouded in a fog of uncertainty, and policymakers know that the wrong move – hiking interest rates too far and too fast to curb inflation, for example – could be disastrous, hopes of a soft landing for the global economy could become a global recession.

Since 1993 there have been only two years in which inflation in the UK has broken through 3%. (Source: Macrotrends 2022) Today CPI inflation in the UK is running at 7% (up from 1.5% a year ago); in the US it is even higher, at 8.5%.

There has been a huge amount of volatility in the markets this year. In early January most of us were welcoming improvements in economic growth forecasts but fretful about rising interest rates. That was sufficient to prompt a rotation from the quality growth stocks that have worked for much of the past decade towards more value-focused and cyclical areas of the market.

Then came the war in Ukraine and, more recently, the renewed Covid crisis in China. With energy prices soaring, supply issues still plaguing the world and inflation shooting upwards, there has been much greater consternation around where inflation – and therefore interest rates – will land.

The falls in the overall market have been discomforting. The S&P 500 is down 16% this year and the NASDAQ down over 25% (as of 10th May). That is painful enough, but it masks some extremely sharp falls in some hitherto well thought of companies.

Netflix’s share price has fallen 66%. The company expects subscriber numbers to tumble by two million in the coming months, with householders reacting to higher prices, deciding between a growing number of competing subscription services and making cutbacks. Rising interest rates have also hurt, meaning investors are revising downwards what they are prepared to pay for stocks that were priced for ambitious growth.

The poster child for market exuberance in the past couple of years has been Cathie Wood’s actively managed Ark Innovation ETF. It is down 68% from its market peak just over a year ago. The party has ended.

On inflation, our view last year was that it was likely to be stickier than the market was pricing in. Today we think the pendulum has swung too far the other way. The ‘transitory inflation’ narrative of 2021 has changed dramatically. The Fed has become especially hawkish.

We are not so certain that we are really going to have the rapid 300 basis points of rate hikes that the Fed is indicating in the US. That feels very aggressive. A combination of some more modest rate rises together with quantitative tightening beginning in June may well curb demand and inflationary expectations. Although the Fed has a dual mandate to control inflation and promote economic growth, Jerome Powell will want to be remembered for delivering a soft landing for the US economy, not a recession.

If you combine fiscal and monetary policy, we have effectively gone from a period of record loosening to record tightening – and in record time. Is the Fed doing its job by simply talking, prompting tighter financial conditions without the need to actually go as far as it suggests it might? Real broad money growth has already fallen sharply, and that is before quantitative tightening starts in June, that will further squeeze liquidity.

We are already seeing tentative signs of improvement in the inflation outlook. Used car prices, which have been a huge component of US inflation, are starting to roll over. Likewise demand for labour has begun to ease if recent data from leading online recruiter ‘Indeed’ is to be believed.

Investors’ fear is that an economic slowdown and the need to squeeze inflation becomes a recession – that slowing money growth turns negative, tightening liquidity conditions cause negative economic growth.

Clearly, there is an enormous pressure on consumers at the moment. The UK is at the vanguard of this; the US less so as energy prices (particularly gas) have not risen as much. This is another reason to be cautious about the outlook. Consumer confidence is dented, the propensity to consume has fallen. There is a very significant challenge to discretionary spending, caused by rising energy and food prices and not helped by supply chain constraints. Some of this has yet to feed through. Despite this, many consumers have emerged from Covid with increased discretionary income – either through savings built up because of the inability to spend during lockdown or generous government fiscal policies in many countries around the world. However, we acknowledge we could hit a significant air pocket in consumer spending as those higher energy bills begin to bite, and food inflation continues into the autumn.

So where does this leave investors? With inflation running so high, being out of the markets and in cash is painful. Being in the wrong part of the market can also hurt.

And who knows what is coming next – soft landing or recession?

This is a time for balance. It is a patient stock-pickers’ market. Within our own portfolio we are focused very much on high-quality businesses with pricing power and sensible valuations. A good example of this might be Coca-Cola which we added to the portfolio during the pandemic, which has just reported better than expected revenues resulting from 7% price increases on the back of 11% sales growth. It is paying us a little under 3% in yield. 

Even holding good stocks does not protect you from what we believe to be markets overplaying concerns. Our holding Home Depot, the US DIY and home improvements company for instance, has been a phenomenal business for decades, but it has recently underperformed on expectations of a reduction in housing-related activity and a decline in DIY spend.

We have not been engaged in some of the more speculative areas with crazy valuations. It is generally healthy, frankly, that some of those valuations have come back to Earth. However, in their wake they have pulled down others that were not ridiculously priced. We may begin to see a bit more rotation back into some of the quality growth companies – like stocks we own such as Microsoft and Alphabet (both down 22% year to date 10th May). Is this a buying opportunity? Or is it too early to step up to the plate? In our view many stocks in the market are now beginning to discount a recession in 2023.

If central bankers are in a difficult position at the moment, so are investors. I do not think this is the time for making big bets on the short-term macro-economic cycle. We prefer to focus our efforts on identifying companies we believe are able to grow cashflow and dividends to shareholders in the medium to long term.

Seldom has there been a better argument for drip-feeding money into the markets and having a diversified and balanced portfolio.