Rising inflation pierces investor complacency


It was too good to be true and maybe it was. The Panglossian optimism that prevailed in the markets over the summer faded thanks to perceptions of weaker growth dynamics in the global economy and, more specifically, in these two engines of global growth, the United States and China.

Business and consumer confidence has weakened, job growth has been disappointing, energy prices have skyrocketed and supply bottlenecks are everywhere. This, in turn, has sparked growing concern about inflationary pressures.

Central bankers who previously insisted the spike in inflation was purely transitory are now in doubt, citing the possibility that they will soon cut back on their support for a recovery that now appears to be faltering. In a delicately revisionist phrase, Andrew Bailey, Governor of the Bank of England, talked possible circumstances in which “the ephemeral would be longer”.

Since September, this has resulted in lower stock prices and higher bond yields. This caused problems for conventional portfolios comprising 60 percent stocks and 40 percent bonds. The change in correlation between the two asset classes means that there is no longer a rise in bond prices and falling yields to compensate for the pain if stock prices fall.

This is what happened during the great stagflation of the 1970s, also marked by soaring energy prices. It took dramatic hikes in interest rates to curb skyrocketing inflation expectations. Under Paul Volcker, the US Federal Reserve raised its key rates to nearly 20% in 1981. In an effort to re-anchor expectations, the Fed has kept rates above inflation into the new millennium.

In the early 1980s, the economies of the developed world were much better equipped than they are today to cope with sharp hikes in interest rates. Debt levels were low while today, due to the pandemic, global debt in 2020 jumped up by 14 percent to a record high of $ 226 billion, after experiencing a sharp increase earlier after the 2007-2009 financial crisis. This reflected the ultra-accommodative monetary policy of central banks which encouraged borrowing and a bond market bubble.

Another consequence of the Fed’s suppression of Treasury yields through its asset purchase program, highlighted by Steven Blitz of TS Lombard, is that stocks have become an outsized percentage of household net worth in the United States. United States and therefore have a disproportionate impact on discretionary consumer spending. He thinks the implication is that an overvalued stock market has become a vigilante governing the actions of the Fed.

It seems counterintuitive. Bond market vigils in the 1970s imposed fiscal discipline by refusing to buy excessive government debt issues on the primary market. An equity vigilante today would sell stocks in the secondary market to push central banks into monetary indiscipline.

Still, Blitz is on to something. There is no doubt that if the monetary authorities normalize their policy, the resulting tightening of financial conditions could harm the recovery.

In his last Global Financial Stability Report, the IMF says there is significant uncertainty about the effect of normalization on asset prices given the larger role central banks play in sovereign bond markets, the expected increase in supply government IOUs and diverging monetary policy cycles between countries.

If anything underestimates things due to the extraordinary extent to which central banks have nationalized the global securities markets. The IMF’s own figures show that the monetary authorities have increased the assets held on their balance sheets to almost 60% of gross domestic product, nearly double the level that prevailed before the pandemic.

Any reduction or reversal of the support central banks now provide to the global economy and markets could therefore have a devastating impact. Central bankers know this, and they also know that if their response to rising inflation precipitates market collapse and a recession, it could cost them their independence.

It follows that there could be a behavioral bias in favor of caution and delay in tightening. Yet the lessons of monetary policy in the 1970s and 1980s were that if the rise in unemployment resulting from an early tightening could easily be corrected by a change in policy, a delay would cause inflation expectations to slip. A much tougher policy and a deeper recession were needed to bring inflation under control.

The delay was actually the Fed’s response under Arthur Burns, who insisted that the rise in oil and food prices was not a monetary phenomenon and should therefore be ignored. This is how the United States arrived at a benchmark interest rate of around 20% and a horrible recession in the early 1980s. Few people now doubt that central banks will soon cut their programs. asset purchase.

Yet investors’ deep conviction that monetary authorities will always come to the rescue if markets collapse suggests that weakness in bond and stock prices will not yet turn into a rout. Having said that, we are in an unstable equilibrium. In due time, something must give.

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