Written by George Lagarias, Chief Economist at Mazars Private Client
The combination of centrifugal forces in global diplomatic and trade relationships, the lack of breakthrough technological achievements, the Chinese economic model shifting and the end of the low-cost-of-capital era all contribute to higher economic and financial volatility.
Outlooks, our own included, paint quite a grim economic picture at the start of the year. Inflation is really an independent variable and, even if the rate of price rises moderates, prices themselves are set to remain high. Meanwhile, central banks are determined to put the brakes on economic growth in a bid to prevent inflation from becoming entrenched. Thus, the oncoming recession is a near-certainty, especially for lower-income consumers, not because the forecast is thus, but because it’s expressly engineered as an inflation-fighting tool.
Meanwhile, Quantitative Easing, the ‘Only Game In Town’ for risk assets for more than a decade, along with the Fed Put, has, for the time being, stopped. This does not mean that central banks do not remain lenders of the last resort of course. The BoE happily bought circa £70bn of UK bonds to avert a systemic risk two months ago, before promptly resuming rate hikes. It does mean, however, that investors can’t expect central banks to shoulder part of their risks when they invest.
The difficult next six months…
That’s bad news for investors over the shorter term, for sure. But we are now easily beyond the shorter term. The downturn has lasted for almost a year. By historical standards (which are reinforced when robots do a lot of the trading) bear markets last for eighteen months. This quite handily fits with the economic narrative as well. Central banks are already seeing lower inflation.
However, China’s sudden reopening, after two years of zero-Covid policies could cause demand from the East to surge again, temporarily causing another inflation shock as it did in 2021.
This is why central banks remain hawkish, as they would prefer the ‘Chinese wave’ to pass and then reassess the state of prices.
…and [possibly] better thereafter
If all goes well, economists expect convincing evidence of an inflation drop in the second half of the year. About the time central banks would begin to ‘pivot’, signalling to private capital that it can finally stop waiting on the side-lines.
Markets are already discounting monetary easing, despite the Fed’s warning that this is not the case for the next few months at least. This has kept equity prices in the US balanced. The larger picture is that while inflation may come down, and central banks eventually revert to form as protectors of short-term capital as well as long, the case for 2008-2021 style monetary easing is still very difficult to make. Central banks abhor expanding balance sheets and flat yield curves and would take any opportunity to escape the QE trap. The resilience of the global financial system allows them room to be more hawkish.
Meanwhile, the combination of centrifugal forces in global diplomatic and trade relationships, the lack of breakthrough technological achievements, the Chinese economic model shifting and the end of the low-cost-of-capital era all contribute to higher economic and financial volatility.
So where does that leave investors?
Inflation is very unpredictable and central banks would tend to be reactive in their policies. Only when they are certain that prices are rising at a diminishing rate will they change their stance, unlocking vast amounts of private capital.
The best way for investors to benefit is to take advantage of lower valuations where they can find them and hope for mean reversion. If monetary easing is not the sole factor driving markets, then ‘value’ and ‘quality’ stocks might not have to wait for years before markets realise their potential and restore their valuations.
If we assume that macroeconomic and financial volatility will be a fixture in the near future, then ‘buying low’ and ‘selling high’, i.e. returning to traditional investment principles could be the simplest and most effective strategy forward.
What goes for stocks, goes for bonds. Finding a yield that is acceptable, for a duration that is acceptable and at a risk investors are willing to assume will be a lot easier now that interest rates are higher. 2022 was the year of the great reset for bonds. From here on, and barring a financial accident, as long as central banks don’t return to zero-rate policies, bonds will be a part of the portfolio for the yield, a much more predictable source of return than capital appreciation.
The extra volatility in the near future means that long-term private investors will need to move quickly when they find an opportunity. They would have to be patient, but ultimately the ‘faster money’ would help them realise the value they bought in quicker than in the past.
Central Banks and Inflation
The idea that central banks can prevent inflation from eventually changing consumer behaviour by raising interest rates below the level of inflation is not right. When rates are 4% and inflation 8%, smart consumers borrow at a lower rate and wait for inflation to eat their debt away. The only reason they have not done so is a) that consumer inflation expectations remain ‘anchored’ near the 2% threshold and b) that 20 years of wage stagnation are not helpful in awakening consumer animal spirits. Central banks hope this remains so. They don’t want to have to raise rates too much, because they fear the huge amount of global debt (360% of global GDP) that would need refinancing. So they planned ‘shock tactics’, i.e. very fast rate hikes, hoping to bring down demand enough to prevent businesses from doling out wage raises as a result of inflation and tight jobs markets.
The downside of this is that they engineered a global recession, out of fear that consumers might become bolder than in the past. However, so far, it’s not consumers that move inflation (again, the central bank fear is that they might get used to it and change behaviours) but constant supply-side shocks (the pandemic, war and energy prices, China closing and reopening etc). Thus inflation remains at the mercy of supply-side pressures while central banks try to suppress demand as much as they can to ease it and prevent it from becoming entrenched in the consumer psyche.