After a dreadful six months, markets are starting to bet on a softer landing.

The media has been full of bad news this past week. Faltering global growth, higher inflation forecasts and rising interest rates set a pessimistic tone, which was made worse by a geopolitical crisis in Taiwan.

UK investors were stung by Andrew Bailey, the Governor of the Bank of England’s dire warnings of a 13% inflation peak and a protracted recession, predicted to last for five quarters. The looming UK recession was suggested to outlast the recession that following the global financial crisis in 2008/09.

For global investors, the more pressing issue is China’s military bravado across the strait of Taiwan. Experts largely agree escalation is in nobody’s interest, but is still very possible. On Friday, Chinese officials announced an end to military and climate cooperation with the US. Further such moves would be damaging – particularly against the backdrop of a weak global economy.

With all this gloom, it might come as a surprise that capital markets are in good spirits. However, since the start of July, equity prices have rallied and bond yields have fallen. Almost all major stock indices had a positive month – with some seeing very substantial gains. So, why are investors so unfazed by the current bad news?

Judging from bond markets, the feeling is that we have reached peak global inflation, and consequently peak interest rate pressures on central banks. Oil prices have started falling and the actions of oil producers themselves point to a belief that current prices are unsustainable. Supply chain bottlenecks clogged by the pandemic are also improving, while consumer demand has clearly taken a hit due to the cost-of-living crisis.

The thought is that this will cause a reversal of central bank policy sooner than previously expected with implied US rates peaking by the end of this year. Investors have essentially given central banks and particularly the US Federal Reserve a vote of confidence. Its policies are expected to prevent a dangerous wage-price spiral while maintaining the economy at a decent level. What’s more, middle-class consumers still have considerable savings to fall back on, while jobs remain plentiful with 528,000 new jobs created in the US in July and businesses are more financially sound than in previous downturns. Recessions in many regions are expected to be shallow and brief, while the US might avoid one altogether.

The problem with this view is that it contradicts what central bankers themselves are saying. Fed Chair Jerome Powell’s speech last week gained praise for its seemingly dovish tones, but he still committed to raising rates and beating inflation. The disparity is even more apparent in the UK, where Bank of England Governor Andrew Bailey and his team issued warnings as dire as they come.

We suspect that the alarmist language is more a warning than a genuine prediction. Monetary policy works on a very long lag, meaning that tweaks to interest rates now will only have an effect a year or so down the line. But if bond markets are to be believed, inflation will already be largely under control by then – meaning further tightening would be overkill. Central bankers want to tame inflation right now, and the only way they can do this is by affecting consumer and business behaviour. They will hope that pessimism will stop employees pushing for higher wages, bringing down cost pressures.

Monetary policy works on a substantial lag, and if markets are right that inflation is at (or close to) its peak, further aggression from central banks will do little to quell short-term price rises. Instead, Fed hawkishness will only serve to worsen growth in the future. Not wanting to unwittingly cause or worsen a potential recession down the line the Fed is likely to loosen its grip if inflation is in retreat.

Markets seem to be betting on the proverbial ‘soft landing’, where a central bank manages to tame price pressures and slow growth without causing mass bankruptcies or outright recession. Economically speaking, this is certainly possible. Recent business sentiment surveys point to falling price pressures without a stepwise fall in output. Increases in labour participation throughout the year are similarly reassuring.

US inflation was 8.6% in May and rose to 9.1% in June. July’s inflation figures come out on Wednesday 10th August and will be viewed for any signal that inflation has peaked. This would be an outcome that would rally equity markets. The suggestion that we may have hit peak US inflation will mean interest rate rises will not need to go higher that that already announced will be a positive. If the announced inflation rates are higher than last month then we are likely to see another fall off.

There are still many risks to the general outlook, which are arguably not as yet fully priced-in. Europe is particularly at risk, facing energy shortages and sharply higher costs this winter. This should bring consumer demand down further and eventually cool inflation, but that could take some time. The main source of Europe’s woes is gas supplies, which are very hard to adjust in the short-term, and are highly susceptible to Russia’s war in Ukraine. European businesses could be the hardest hit, as they have less sway over electoral outcomes and are therefore lower down on politician priority lists.

Markets nevertheless seem to think that the inflation battle is going well, and there is a path to economic recovery. But none of that is certain, and there are many political obstacles that could get in the way. Governmental paralysis in Britain and Italy could prevent decisive policy action, while US-China tensions over Taiwan are a serious and perhaps under-appreciated risk to global growth. Negative news flow, particularly around energy supplies, could severely dampen market sentiment.

At the same time, the huge uncertainty around energy means things could turn out better than currently expected. Elevated gas prices in Europe have become the main concern to the global outlook, but there is very little information on when they might subside.
The prevailing market sentiment is not as gloomy as central bankers would have us believe. At the same time though, policymakers have every reason to sound the alarm, as there are significant risks to the outlook. Given those risks do not seem to be fully understood or appreciated, we cannot yet assume that July’s upswing is anything other than a temporary reprieve. We will be hoping it proves to be something more. Cautious optimism seems the best approach.

---

Comments are closed.