Little Fires Everywhere

As stewards of capital and investment portfolios, the most important question fund managers face today is whether the 40-year trend of disinflation was ending in 2021? There are another four Fed meetings this year and the markets will vote on whether the Fed committed a policy mistake waiting too long or contrarily being tough in raising the rates. The market has moved to а bear territory since the May Fed meeting (in May the Fed announced its interest rate increase by 50 basis points, in June –  by 75 bps).  The big political question in Washington is whether to support the dollar with higher US interest rates or whether the Fed will take the stock market weakness into account when fighting inflation (according to Bloomberg, S&P 500 went down by 23% during the last 12 months).

The current global stock market selloff is unique and worrying  because for the first time since former Fed Chair Alan Greenspan invented the so-called “Fed Put” during the 1987 stock market crash, the Fed Put is no longer effective, having outlived its usefulness because of high inflation.

Large-scale monetary easing by global central banks to aid the global recovery from COVID-19 was spurring economic activity while debasing currencies. The rising prices of gold and bitcoin are visible indications of this as investors sought to hedge their portfolios against inflation. In a world where bonds are increasingly return free risk, gold is the new zero-coupon bond, a safe-haven asset that doesn’t make interest payments at regular intervals.

Nominal interest rates are low in the United States and other advanced economies. Low nominal interest rates may constrain the ability of policymakers to provide accommodation through reductions in interest rates during an economic downturn which is a real threat for many countries, including the United States. As the Fed waited too long when the stock market was in a bull market, now we have many questions. Can the markets and the economy survive large monetary tightening? Will the landing of the economy be soft?  These are the key issues because inflationary pressures take a toll on average people.

The unfortunate truth is that military actions and counter-sanctions have stimulated inflation, which had already been on rise during the pandemic recovery (in logistics, supply chains, and changes in the demand structure). According to Consensus Economics cited by the World bank in its recent research, global inflation expectations in 2022 accelerated to 6.5% above 4% forecasted in February research, which had been published before the military actions in Ukraine.

Inflation has had a positive impact on analysts’ consensus forecasts for earnings in 2022 and 2023, but it has a negative impact on the valuation multiple that investors are willing to pay for those earnings estimates. Needless to say, the former positive effect has been trumped by the latter negative effect, which can be seen by the jump in U.S bond yields and the rising concerns that US dollar government bond yields will continue to increase and the economy will end up in a recession.

It is sometimes said that monetary policy is like shooting a moving target that you cannot see very well and hence is prone to mistakes. Rising interest rates are designed to slow the inflation, and it also slows down the economy by making borrowing more expensive. But this slowing might be amplified this time around because the interest cycle change will now be bigger and faster than in the past.

Due to the convergence of geopolitical, food, energy, and possible debt and growth crises, a growing number of poorer countries face a rising threat of famine — and this is one part of the “little fires everywhere” phenomenon undermining lives and livelihoods around the world. Inflation is undermining standards of living and growth engines, hitting the poor particularly hard, fuelling political anger, and undermining the effectiveness of economic and financial policy. The word from the 1970's now explains the macro zeitgeist: stagflation. Stagflation is potentially the worst environment for asset prices.

Global financial are turning in bear market territory as investors are not confident that the Federal reserve will stabilise inflation, which hit 40-year high of 8,6% in May. The reality is that the only way to control inflation is aggressive monetary tightening, but it increases the possibility of global recession. The old market saying:  when America sneezes, the world gets a cold. This saying might work again this year.