A muddled inflation picture, uncertainty over if or when rates might be cut and markets at all-time highs: what should investors do?

Global interest rates have been on an aggressive hiking cycle for over a year now. Higher interest rates meant it was more expensive to borrow money with the aim of slowing demand and taming inflation. And it seems to be working. In the US, inflation, which peaked around 9% in the second half of 2022, is now around 3%.

According to Multi-Asset Fund Manager at Schroders, Tara Jameson, the belief that interest rates will fall this year has made assets such as cash and bonds less attractive to investors and sent some stock markets to all-time highs. But recent inflation data out of the US and UK wasn't quite what was expected, sending jitters through markets. “The inflation data recently was a bit of an upside surprise and reinforced some of the concerns that we've had about inflation,” says Jameson.

“Inflation tends to come in waves. And the Federal Reserve has the ability, because the US economy is still so strong, to play a bit of a waiting game - while looking for more confirmation on those data points,” says Alex Funk, Chief Investment Officer of Schroder Investment Solutions.

This effectively presents a triple threat for investors. What to do if inflation remains sticky? How to react if central banks begin to cut rates? And should you fear investing in markets at record highs?

Even if we're on the right path, Funk says that markets have been volatile after each release of inflation data. “Perhaps understandably, nervous investors have reacted to any signs that inflation might remain stubbornly higher. After all, it's been a while now since they were being told that inflation would be transient. It wasn't. And now they're being primed for higher, for longer, both in terms of interest rates and inflation, although not as high as previously,” says Funk.

And, according to Jameson, we are going to see more volatility. “The 3D Reset – the three big structural forces which we believe are impacting the global economy - will create more inflationary pressure going forward. The 3Ds are demographics, deglobalisation and decarbonisation.”

Ageing populations are creating labour shortages, which are pushing up wages. Reshoring or rerouting supply chains to bring security is costly. And cleaning up our energy supply and consumption is expensive in the short term.

“This reset is creating persistent inflationary pressure. While this doesn't mean that inflation is necessarily going to be higher in the end, there will be cycles within it. And the central banks do have a very difficult job on their hands now. They've had to bring inflation down a long way – and there is still more to be done. And while markets may think that they can engineer a soft landing, these outcomes can be binary, and there is always the risk of a hard landing,” cautions Jameson.

But despite the volatility, some markets are trading near record highs. That isn't surprising if you believe inflation has been quashed. But it poses a difficult question for investors. If central banks begin cutting rates, should they be scared about investing in markets in the current environment?

“The market is actually at an all-time high more often than you might think,” says Funk. According to research from Schroders, the US stock market was at a record high in 354 of the 1,176 months since January 1926.

“I think it can feel quite scary buying into markets when they're at all-time highs. And that's where investor psychology comes in,” says Jameson. “Investing at these times is not necessarily a bad thing. The S&P has been at a record high 30% of the time over its 100-year history and the investment outcomes haven't been all bad. Historically, if you’d bought at an all-time high, you'd have beaten inflation by 10.3% compared to 8.6% over other periods.”

Over long time horizons, these differences in returns can seriously add up. “According to our research, if you'd invested $100 into the US stock market in 1926 and just left it alone, didn't touch it, it would now be worth around $85,000,” says Funk.

“Conversely, if you’d invested that same $100; and then you took the money out when markets had hit these all-time highs and then invested in cash and ultimately tried to come back into the market, that same investment would have been roughly 90% lower at just under $9,000. So again, the effect of timing the market, creates some complexities for your investment performance as well.”

Adding to that complexity is the prospect of the Federal Reserve potentially cutting rates. The market is pricing in a nearly 82% chance of a quarter point cut by June. But while the situation can change, it’s worth looking at what has happened in the past, once the Fed starts to cut.

“Data suggests US equities actually outperform by about 11% relative to inflation, on average, from the point that the Fed starts to cut. So the euphoria is effectively being priced back into the market,” says Monk.

Equities have therefore not only beaten inflation, but according to Jameson they've also beaten cash by about 9% on average. “It’s worth remembering that these are averages.  But what we can take comfort from is that in 16 of the 22 cutting cycles we've looked at, we've had a recession as well, and still that average number is positive. So, if the Federal Reserve can engineer a soft landing with this cutting cycle, then actually equity markets stand to do fairly well,” says Jameson.

So, is cash dead now for investors? Jameson believes that cash is always an option as an asset class. “But I do think that fixed income is becoming more exciting. And the one big difference between government bonds and cash is that government bonds do have that potential to have that negative correlation with equities in a severe risk-off situation. So, we have had times in markets before where equities have been falling and your bonds have generated a positive return in the portfolio. Cash isn't going to do that for you”, she concludes.