Understanding the economic news and 3 questions to ask yourself about your investments

The economy is making headlines recently, so we are going to explain some of the key issues being discussed and what they mean for you as expats in Europe. We will discuss 3 items: inflation, interest rates and recessions.

Inflation

We have been talking about inflation for over two years, since the Covid pandemic commenced and central banks began the rather extraordinary process of ‘printing money’, injecting capital into markets to prevent economic collapse. That was deemed necessary at the time. Remember, in most of the world, shops were closed, people that were able to work from home did so, there was no where to spend earned money, factories and production slowed, and international trade dropped precipitously. The actions of the central banks allowed governments to support companies so they could survive and continue to pay staff and protect against what could have been disastrous global economic collapse. As we said in 2020, an impact of this action would be higher inflation in the future. This is one of the causes.

The other key driver of inflation is still supply shortages. There are restrictions on products coming out of China and other primary producer markets, and from the impact of the Russian invasion of Ukraine. A shortage of supply, pushes up prices.

The next phase of inflation will be important to observe. As long as it is supply driven, it is harder for central banks to control, but easier to dissipate with supply channels returning to open and normal levels. The current inflationary pressures though, could next lead to pressure on wages growth. The likelihood of this is increased because of the low unemployment levels. There are more vacant jobs than people seeking employment in many fields. If wages growth accelerates, it could lead to demand driven inflation. This means people going out and spending more money. This is what the central banks will want to control.

What does it mean for you?

It means that cost of living is going up. You will see this reflected in the price of fuel, the cost of groceries and home energy costs. It is good to review your household budget as costs go up.

It also becomes more important to not hold too much of your wealth in cash. You should aim to ensure you are at least keeping pace with inflation, so you are not eroding your spending power over time. Inflation at 3% pa means your spending power halves in 24 years. If inflation is 8%, it halves in 9 years!

Interest rates

This is the big news at the end of this week. As a result of the rising inflation levels, the European Central Bank has announced they are increasing the official interest rate for the first time in 11 years. They said they will increase rates by 0.25% in July and have further increases planned for September, and then later in the year.

While there is much discussion about this and what it means, it is important to remember we are at historically low levels. After the increase, the ECB’s interest rate is still negative, at -0.25%. That means there is much room to move before interest rates become a problem on their own. Their action is also in step with other central banks around the world, including the US and the UK.

If you are planning on buying a home, or have a mortgage with a variable rate, this will mean your mortgages expenses will increase as the banks pass on interest rate increases.

More interesting, is that the ECB also announced they will end its quantitative easing programme in July. This is the support for the economy we described above and ending it is a necessary step but may result in some shorter term volatility.

Recession

The other big topic being discussed in the news this month is the likelihood of recession. The reasons why this is being raised are because interest rates and inflation are increasing, and consumer confidence and stock markets are decreasing. However, there are arguments against it: strong employment levels, good jobs growth, and solid financial reporting from many blue chip companies.

Janet Yellen, from the US Federal Reserve has stated there is nothing to suggest a recession is in the near future.

Whether the economy in Europe, or the US falls into recession, or when, or not, it is important to understand what a recession is and what it will mean for you and your investments.

What is a recession?

A recession is defined as a period of temporary economic decline that is usually measured by a fall in GDP in two successive quarters. GDP stands for gross domestic product and is a measure of economic activity in a country or a region.

A recession is different from a stock market crash. Sometimes they happen at the same time, eg Feb-March 2020, and other times they do not, eg October 1987.

What do markets usually do? Even if there is not a crash event on the markets, they will have increased volatility and a steady decline, much like we have seen in the first part of 2022.

In looking at the markets in 2022, what we don’t know is how far the markets will continue to fall and for how long. When looking at what the markets might do next, we urge you to be cautious and to be wary of those that think they can predict the markets. Experience says this is not possible.

What we do know, from research from the US National Bureau of Economic Research, is that after markets contract due to recessions they typically enter a period of growth. The table below shows the main recessions going back to the first one after WWII in 1948-49 and how stock markets responded leading up to the recession, during the recession and in the period of one, three and five years after the recession.