Are we nearly there yet?

Market report

• The central bank fight against inflation remained centre stage for investors
• The biggest interest rate rise since 1994 in the US…
• More from the Bank of England
• Stock market pull-back – are we nearly there yet?

CIO view

It is perhaps time to fill the car with children, beach balls, and (if sensible) warm clothes to head for a holiday at one of Britain’s many lovely seaside resorts. Lurking is the sense that the journey there may re-connect you with a sense of the eternal. Hours, seemingly days, spent chewing over the ultimate question, as you gaze on Stonehenge with growing distaste – are we nearly there yet?

Investors likely face a summer of similar fare. We are going to have to wait and see to what extent the central bank fight to contain inflation (and our expectations of inflation) is successful. Will the central bankers have to force their various charges into recession(s) in order to win? How high will interest rates have to go?

These still unanswerable questions are urgently circulating amongst investors. The attempts to handicap likelihoods and install them in prices continues to make for a turbulent and unfamiliar backdrop. In some senses, much of this is a healthy development (investors who entered investments for the first time this year may understandably feel different). The point here is that investors are in the process of correcting an extrapolative error, one increasingly embedded through the last economic cycle. Inflation is no longer perceived, or priced, as a beaten foe. Correctly, the mix of incentives available from assorted investments are starting to offer a bit of extra compensation for the risk that inflation is back more durably.

This could easily not be the case of course. As we’ve suggested before, we could easily still be still stuck in the same macroeconomic tram lines of previous to 2019. Ever lower, more quiescent inflation and ever lower real interest rates are two of the important calling cards and what we are seeing at the moment, just a spasm resulting from pandemic era policy and other passing factors. However, the question occupying investors at the moment is what if that is not the case? What if we are in a new macroeconomic paradigm, one where inflation is a thing again?

As we’ve warned many times before, conviction needs to be low on this issue. Most of the attempts to correctly identify the prevailing macroeconomic, societal and other paradigm will be wrong if past is prologue. Sometimes, the most important aspects of the era we operate in will only become obvious in hindsight. Besides which, we shouldn’t need reminding that inflation remains an unpredictable and elusive foe. The fact that US inflation data are still capable of positively surprising forecasters is surely suggestive.

From a policy perspective, we would be wise to expect a tough summer as noted above. The Federal Reserve may not feel the need to continue to raise interest rates in such historic increments in the months ahead, and certainly market pricing feels better prepared for the chances that they will need to. However, with stock and bond markets very much part of the monetary conditions that the central banks are targeting, signs of victory against inflation may be needed before relief can be felt.

The interests of longer term investors are more fully aligned with those of central bankers. In the quandary over how much short-term economic damage central banks will need to inflict in order to bring inflation to heel, the (mandated) priority is inflation in most cases. There are nuances here of course, however the point is for the longer term investors – the next recession is almost irrelevant. Much of the expected slowdown is already well priced by markets. What would have a more material effect on your long-term returns is the counterfactual world where the Federal Reserve, Bank of England, and European Central Bank followed Turkey’s eccentric example – prioritising short-term growth over the battle against inflation expectations and thereby creating a truly unplayable macroeconomic context.

The longer term prospects for returns from diversified investment remain reassuringly founded on humanity’s barely touched innovative capacity. However, for the shorter term, diversification, humility, and patience may well be the important watch words.?

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*This article is for information purposes only. It is not intended as a product offer or investment advice