Given the dismal performance of stock and bond portfolios over the past year, you may not have realized that financial markets are soaring on optimism. Yet there is no other way to describe investors today, who since the fall have been increasingly betting that inflation, the biggest problem in the world economy, will go away without too much fuss. The result, many believe, will be interest rate cuts towards the end of 2023, a move that will help the world's major economies (and the United States above all) avoid a recession. Investors are pricing stocks for a Goldilocks scenario where company earnings will grow healthy while the cost of capital falls.
Anticipating that turn of events, the S index
It's not just the US markets that have skyrocketed. European stocks have risen further, thanks in part to a mild winter that has tempered energy prices. The money has poured into emerging economies, which are enjoying the double fortune of China's abandonment of zero covid policy and a cheap dollar, the result of expectations of looser US monetary policy.
It is an optimistic image. Unfortunately, it probably doesn't match reality. The global battle against inflation is far from over. And that means the markets could be in for a nasty correction.
As an indication of what has raised investor hopes, let's look at the latest US consumer price figures, released on February 14. They show lower inflation in the three months to January than at any time since early 2021. Many of the factors that caused inflation to take off have dissipated. Global supply chains are no longer overwhelmed by increased demand for goods, nor disrupted by the pandemic. Demand for patio furniture and game consoles has cooled, property prices are falling, and there is a glut of microchips. The price of oil is lower today than it was before Russia invaded the Ukraine a year ago. The picture of falling inflation is repeated around the world: the headline rate is falling in 25 of the 36 richest OECD countries.
However, fluctuations in headline inflation often mask the underlying trend. If we look at the details, it is easy to see that the inflation problem is not solved. US "core" prices, which exclude the more fluctuating food and energy prices, have grown at an annualized rate of 4.6% over the past three months and have begun to accelerate slightly. The main source of inflation is now the service sector, which is more exposed to labor costs. In the US, UK, Canada and New Zealand, wage growth remains well above their respective central banks' 2% inflation targets; wage growth is lower in the euro area, but increases in major economies such as Spain.
That shouldn't come as a surprise, given the strength of labor markets. Six of the rich G-7 countries have an unemployment rate at or close to the lowest in this century. The US is the lowest since 1969. It is hard to see how core inflation can dissipate if labor markets remain so tight. They keep many economies on a path towards inflation of no less than 3-5%. That will be less frightening than the experience of the last two years; but it will be a big problem for central bankers, who are judged by targets. It will also mean puncturing the balloon of the optimistic vision of investors.
Whatever happens, turbulence in the markets seems likely. In recent weeks, fixed income investors have started to lean towards the forecast that central banks will not cut interest rates, but rather keep them high. It is conceivable – just that, conceivable – that rates will remain high without seriously affecting the economy, while inflation continues to decline. In that case, markets would benefit from strong economic growth. However, persistently high rates could inflict losses on fixed income investors, and maintaining high risk-free returns would make it more difficult to justify trading stocks at a high multiple of earnings.
Instead, high rates are much more likely to hurt the economy. In modern times, central banks have been bad at "soft landings," completing a cycle of raising interest rates without a subsequent recession. History is full of examples of investors who erred in anticipating strong growth towards the end of a period of tight monetary policy only to find themselves hit by a recession. It has happened even in less inflationary conditions than the current ones. Even if the United States were the only economy to enter a recession, it would also drag much of the rest of the world down with it, especially if a flight to safety strengthened the dollar.
There is also the possibility that central banks, faced with a stubborn inflation problem, will not have the stamina to tolerate a recession. In reality, they should allow inflation to run slightly above their targets. In the short term, that would be a "sugar rush" for the economy. It could also be beneficial in the long run: Over time, interest rates would rise due to rising inflation, keeping them away from zero and giving central banks more monetary ammunition in the next downturn. For this reason, many economists think that the ideal inflation target is above 2%.
However, managing that regime change without wreaking havoc is a daunting task for central banks. Last year, central banks insisted on their commitment to current targets, often set by lawmakers. Abandoning one regime and establishing another is a once-in-a-generation political challenge. In the 1970s, the lack of clarity about the objectives of monetary policy caused strong swings in the economy that hurt both the general population and investors.
For now, the central bankers of the rich countries are showing no sign of wanting to change course. Yet whether or not inflation slows down or they give up fighting it, policymakers are unlikely to pull off a flawless turnaround. Whether it's rates staying high, a recession hitting, or politics entering a tricky transition period, investors are going to be in for a treat.
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Translation: Juan Gabriel López Guix
