Markets grapple with stagflation

Central banks could make a policy error, but the Fed may become less hawkish this summer if, as expected, inflation starts to fall and wage pressures do not accelerate.

| 8 min read

Thursday’s sharp US equity sell-off followed a period of reflection on hawkish statements from the Federal Reserve about its plans to curb inflation. It was a reminder that markets do not like slowdowns generated by tighter money.

There is the risk of large falls in output for some businesses and squeezed company profits for many. The immediate response to the Fed’s announcement of the expected 50-basis-point (bp) rise in interest rates the night before had been favourable. Commentators said rate rises were now priced in and expressed pleasure that the Fed Chairman had ruled out any 75bp hike or faster. He did, however, rule into consideration a couple more 50bp rises soon to be followed by additional 25bp rises thereafter. He also confirmed a lively pace of balance sheet contraction, to hit $95bn a month in three months’ time – staying there for many months thereafter.

So, why the second thoughts?

Leading central banks – and this includes the Fed – only have one policy for bringing down inflation. That policy is damaging to output. They raise interest rates, stop printing money, and reduce the size of their balance sheet support to commercial banks and the wider economy. The aim is to reduce the rate of growth in credit and money by the commercial banks.

Higher rates put people off borrowing. Tighter money restrains the amount of credit banks can lend. Everything from property deals to new car purchases, from homes to general consumer purchases on credit are affected. Volumes decline and prices are restrained by more sellers chasing fewer consumers.

Our base case is predicated on the central banks getting it right.

If a central bank tightens too much it can do more than just slow an overheated economy. It can result in a fall in overall output. This cuts the turnover of many businesses, so they spend less and invest less, dragging activity down more. Hawkish language by the Fed has its own impact, making people less optimistic about the future and deferring purchases.

Our base case is predicated on the central banks getting it right. If they have the “goldilocks touch” they will raise rates and restrict credit enough to slow the economy but not so much that they force it into recession. The relatively high probability we place on the alternative bear case points to ways we could face worse conditions for longer. It has, as one of its main themes, the possibility of a central-bank overshoot.

The bear case

The central banks made bad mistakes last year in continuing a huge Covid-19 stimulus package for longer than was needed. This resulted in soaring inflation. Now there is the danger they will overreact and do too much the other way. The credit excesses of 2005-7 led to extreme measures by central banks on both sides of the Atlantic, moves which brought on the banking crash and great recession of 2008-9. Arguably, both the monetary laxity of the first phase and the severity of the correction were policy errors.

The bear case also includes factors such as a worsening of global energy shortages and trade disruptions, as well as the re-emergence of a serious Covid-19 variant that requires new lockdowns, and the impact of high inflation on consumer behaviour. Unwelcome political outcomes in unstable countries is another base-case factor.

Most central banks face the dilemma of stagflation. Do they toughen more to kill the inflation first – at the expense of a recession, or do they go for a mid-course and try to prevent recession whilst seeing some reduction in price pressures?

In periods of past bad inflation, they have usually created a recession to try to kill the inflation off. Currently, the advanced-country central banks are diverging in policy as they face somewhat different issues. Japan can carry on with a very loose monetary policy and zero interest rates because inflation remains low by world standards. Japan still wants to fight slow growth and get prices up a bit.

The European Central Bank (ECB) has still to end quantitative easing let alone raise interest rates, despite worrying inflation, several times higher than target. It seems restrained by the slowdown that is happening anyway in the economy, with the impact of the Ukraine war adding to the woes of the cost-of-living crunch. It is also nervous about the impact of higher rates on state finances in several parts of the Eurozone – and on the credit positions of some commercial banks.

US problem more acute

The Fed has the biggest inflation and the strongest economy to rein in. For that reason, it is still in inflation-fighting mode, spurred on by a Democrat President who needs to demonstrate strength in fighting the cost-of-living pressures that rising prices have created. This President does not worry, as his predecessor did, about keeping up the valuations of equities and bonds.

US Treasury bonds fell further last week following the hawkish tone of the Fed. Given the current drift of US policy, we may see a longer period of market unhappiness before it is clear if the Fed will find a sweet spot between slowing growth and controlling prices – or not.

Long bonds will be a good buy once markets can get some greater clarity over when we get peak inflation and when the Fed’s tightening cycle can end sometime after that. Equity analysts need to start factoring in output slowdowns and less ability to pass on inflation in prices. Our emphasis on companies that can continue to grow their top lines and maintain their margins because of their market power becomes ever more important.

The more hawkish the central bank is concerned, the more valuations of shares will be squeezed.

As we have seen in these difficult times, any growth company that stumbles on either turnover or margin will suffer a sharp downwards correction in price. The more hawkish the central bank is concerned, the more valuations of shares will be squeezed by fears of what impact an economic slowdown will have on earnings and dividends.

In many of the advanced countries, the better-off consumers still have substantial additional savings accumulated over long lockdowns which prevented travel, entertainment and hospitality expenditure. This is creating the anomalies of some high-end activities doing well as the rest of the business world has to cope with the impact of the cost-of-living squeeze on most people. In the corporate world, we will also see a divide between those which, like the oil and gas companies, make a lot of money out of current woes – and the other businesses that face harsher realities.

Muddling through

It is looking more likely that the cost-of-living crunch itself and central bank action to date will slow economies and prevent a general embedding of inflation. Wage settlements are staying well below inflation on average. Inflation gets much tougher to eradicate when wages rise quickly, chasing prices in a self-defeating spiral. If and when the Fed thinks that scenario has been averted, it can moderate its stance. Meanwhile, the other central banks are relying more on the cost-of-living squeeze doing the work for them and restraining demand.

The increases in the price indices that worry people will reduce over time, once the now much higher prices of energy and food are baked into the index already. Concerns will centre around the Fed doing too much and the ECB not doing enough. Given their different backdrops, they could both muddle through. The ECB is going to have to do a bit more to curb inflation soon, whilst the Fed may become less hawkish this summer if, as expected, inflation starts to fall and wage pressures do not accelerate.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Markets grapple with stagflation

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