The Ukraine war is dragging on with no end in sight. Russia has reduced its energy supplies to Europe, either on Europe’s initiative or because Moscow decided. The Covid pandemic has taken root across the globe as new variants emerge. Production chains are still being disrupted due to China’s zero-Covid approach, a policy that is likely to persist at least until the 20th Chinese Communist Party Congress when Xi Jinping stands for another mandate.
A mediocre environment
Agricultural prices seem to have stabilised overall since March but energy prices have continued to surge. Additional inflationary pressure amid strong demand has only accentuated the fact that some central banks are seriously behind the curve: they desperately wanted to wait for full employment to return before considering any monetary tightening. In the US, there are already signs of a de-anchoring in inflation expectations.
Central bank messages have changed considerably. At the time of writing, investors were expecting the ECB to raise rates by 280bp over 18 months and the Fed by around 230bp. This would be an impressively fast pace and investors reacted so brutally in the second quarter that for the first time in decades, no asset class -including money market funds- has managed to chalk up positive returns so far this year.
Will the monetary tightening expected by markets be enough
Optimists, led by central banks, think -or at least declare- that we only have to get back to neutral rates, and perhaps a little bit more from time to time, to get inflation back relatively quickly to its target level without too much collateral damage to the economy. Sceptics, on the other hand, think that taking the Fed Funds rate to around 4%, the level markets are currently expecting, will not be enough to douse inflation which is already trending higher than that. Quite simply, can we beat inflation when real base rates are negative? Olivier Blanchard, the IMF’s former chief economist, thinks that the Fed has to go as high as 5%.
The coming months will determine what interest rate levels markets should expect to see from monetary tightening. In the meantime, markets will remain under pressure. Were inflation to start falling rapidly, it would be easier for investors to chart the rate hike cycle and wait to see how inflation behaves.
That would be a more favourable scenario for investors as they might hope central banks could limit the risk of tipping economies into recession. If not, current inflation levels and signs that household inflation expectations are de-anchoring, could very well make markets expect more rate hikes.
There are others who think central banks will stop tightening at the halfway stage to avoid a more moderate version of the 1970s’ recession and/or financial conditions. In other words, central banks would end up accepting inflation that is trending above their target levels. Central banks today find it easier to deliver more hawkish messages because of persistent labour market tensions. But will they be able to avoid prematurely easing when their economies turn down?
What unemployment rate would allow US inflation to return to its target?
Judging from their dot plot sheets, some FOMC members think the jobless rate would have to rise to 4.1% to stabilise inflation, or 0.5% higher than the current rate. Such an increase has historically only been seen in a recession. These estimates are fragile but they are reinforcing investor convictions that beating inflation perhaps means a US recession. Valuations are currently discounting a sharp downturn but not a recession.
Could we jump straight from inflation to deflation?
Focusing on interest rates alone risks overlooking the fact that overall financial conditions dictate monetary policy. And central banks have considerable influence on these conditions. The Fed started shrinking its balance sheet in June and at a much faster pace than in its first quantitative tightening in 2018 which led to tougher financial conditions. As in the fourth quarter of 2018, we cannot rule out central banks being faced with another dilemma if markets skid. Should central backs then execute an about-turn and ease monetary policy to rescue markets? They would risk losing their credibility and it has already been hammered in recent months in the fight against inflation.
Given the amount of debt that has built up in the private sector, a market accident from central banks hoovering up liquidity would trigger a vast deleveraging movement that could make inflation jump directly into deflation. The ECB is trying to create an anti-fragmentation strategy to help it tighten financial conditions while keeping peripheral country spreads under control. It is too early to say if it will be successful but central banks have the knack of innovating to reach inflation targets without jeopardising financial stability.
The global economy is down but not out
The fact that central banks are late in the tightening cycle has never been more obvious. However, the risks are high as we can easily imagine dire scenarios where central banks are either too lax, or so restrictive that they trigger a financial market crash. They will have to be very nimble to reach their targets without causing too much damage. The good news is that they are catching up and despite today’s turbulent geopolitical and market environment, the global economy is down but not out.
Economies in the West are slowing but China should pick up. Disinflation might possibly be just ahead. In recent weeks, commodity prices have all been falling back significantly now that markets are worried about growth. And, despite shortages, some sectors have perhaps overstocked so deliveries could be facilitated and downward pressure on prices might begin.
For the moment, we remain cautiously positioned but we are on the watch to reinforce exposure. There are numerous opportunities in emerging country and high-yield debt as well as in equities.
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July 2022. This document is issued by the Edmond de Rothschild Group. It is not legally binding and is intended solely for information purposes.
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