By Jonathan Sloan

It is fair to say that 2022 has not unfolded as most people would have predicted – or indeed, would have wished. Just when we had an expectation that we were finally moving into a “new normal” world of post-Covid acceptance, the war in Ukraine has brought that level of optimism crashing down.

One of the key focuses of a professional investment adviser is to imagine and plan for a future with multiple potential outcomes. This enables one to keep a foot in many camps, with the expectation that some of these outcomes may never materialise, yet the risk of over or under exposure has been managed.

On this note, the predicted dominant economic theme of 2022 was widely tipped as being inflation – sometimes categorised as “cost-of-living squeeze” – with predictions of temporary or transitory inflation emanating from pent-up demand and supply chain challenges post-lockdowns.

However, the conflict in Ukraine, resultant sanctions against Russia, the impact on the price of oil, and most likely the rising cost of European food, have rather complicated that debate. It leads to the suggestion that one potential future outcome may be the return of stagflation – whereby inflation runs higher than desired and growth is lower than the target output. Investors should consider this as one potential outcome of recent events.

To guide us in our asset allocation – so we weather whichever economic storms we encounter along our investment journey and ensure we avoid the worst of over- or under-exposure – it is worth analysing the current state of play and how we have arrived here. By carefully using this information, it can help forecast a number of possible outcomes, which may continue to evolve over the coming months and years.

The last few decades have been characterised by an abundant supply of workers and commodities that have helped to keep price pressures contained amidst decent demand growth. This supply side abundance has kept inflation broadly in line with central banks expectations.

What we are experiencing now is quite different, with a clear gap having emerged between the availability of labour and the number of job vacancies to fill. This is manifesting in a push in wage inflation. While some of that is likely temporary, what has become clear is policymakers and central banks have an unenviable balance to strike to get this right and we cannot avoid the fact we are in a far from “normal” world.

Similarly, recent CPI figures in the UK and US suggest inflation risk will be at the forefront of decision-makers’ minds in 2022. The Bank of England raised interest rates (albeit marginally) in mid-December in its first move to temper inflation, and has since raised it to 0.75 per cent, while the US Federal Reserve has indicated it will implement three rate rises over the next

12 months, starting as early as April. It is unlikely this will be the last of this approach.

At a very basic level, the widely accepted strategy for combating inflation is indeed to raise interests. As we know, higher rates encourage more saving and less spending by consumers, which in theory leads to a reduction in prices as demand for goods and services falls. However, with the pandemic continuing to disrupt many businesses, and in turn productivity and employment rate, central banks are facing a “stick or twist” dilemma over inflation.

The added complication is the yet unquantified impact of Russian sanctions, and disruption in fuel and potentially food supplies, which will result in a more significant cost-of-living squeeze than originally thought. This has led some to worry about the return of stagflation and how central banks (and governments) will deal with that.

The “stick” approach would be to try and navigate the inflationary path with composure, with the assumption that supply chains – which became blocked during the pandemic – will continue to unclog in coming months and quarters. This will increase supply to help meet the pent-up demand now being seen. As a result, some of that pricing pressure would be released without too much intervention from central banks.

In stark contrast, a “twist” approach could potentially see rates significantly hiked and on a much steeper trajectory, with the expectation inflation would ease as spending and savings habits adjust accordingly to a higher rate environment. However, with the recent complications in the supply chain easing for much of the western world, this approach could be problematic.

Major central banks seem much more minded to the “stick” approach, and there are several reasons why this remains the consensus strategy for the time being. After all, there is the real possibility inflationary pressure will indeed ease as supply chains return to full capacity, which would go some way to solving the problem on its own, or at least in part.

However, the major motivation for this relatively passive approach is perhaps the fear that if rates are hiked too much or too quickly, the prescribed cure could be worse than the inflationary disease, with the impact to consumers being significantly higher interest rates on mortgage repayments and credit card bills.

There is also the potential for a significant impact of steep rate rises on capital markets to think about. Share and commodity prices, bond yields and the foreign exchange market would all be affected in different ways, which could lead to anxious times for investors and businesses alike. And it is fair to say markets have no need for more uncertainty at this moment.

As always, but especially now, central banks must walk an economic tightrope to balance the needs of the consumer and the investor – and to ensure an imbalance does not occur. No matter the outcome, investors should exercise the right level of humility and hold a suitably diversified group of assets.

Jonathan Sloan is regional director for Barclays Wealth Management and Investments in Scotland.