For most investors, the last two years have presented extraordinary challenges, as well as opportunities. Even though central banks had already been pursuing aggressive policies for over a decade, ever since the onset of the pandemic, we entered completely uncharted territories with regard to monetary and fiscal policies and we’ve witnessed unprecedented measures in response to the covid crisis. And just when we thought it was finally over, most of the world was caught by surprise by the Russian invasion of Ukraine.
Apart from the obvious humanitarian tragedy, this new crisis has unleashed a myriad of fresh challenges for the world economy, disrupting trade flow and once again clouding global growth prospects. However, the economic downturn that very likely lies ahead has long been in the making.
Short-term solutions to long-term problems
Despite the narrative that is being so often repeated by politicians and the mainstream financial press, the reality is that inflation is not a new problem. And while the war in Ukraine might have exacerbated it, it most certainly didn’t cause it. Higher-than-expected CPI readings have long preceded this latest crisis. Americans and Europeans alike have been feeling these pressures in a very real way for months already, as food prices and energy costs exploded and as wages failed to keep up. In the US, inflation stood already at 7.5% before the conflict broke out. Although President Biden rushed to blame the phenomenon on “Putin’s price hike”, as he recently put it in a press conference, the US Bureau of Labor Statistics reported in March that over the last twelve months, the all items index rose by 8.5%, the biggest jump since 1981.
In fact, the entire approach to the issue of climbing prices appears to be wholly misguided. Both politicians and central bankers are trying to tackle inflation as though it were a demand-side problem. This is why we see an increasingly hawkish stance being adopted by the Federal Reserve, pivoting to interest rate hikes and announcing plans to begin shrinking the central bank’s balance sheet. Naturally, trying to roll back some of the unprecedented stimulus we saw during the pandemic and attempting to “mop up” some of the excess liquidity is, in principle, a sound idea. However, there are two glaring problems with this “remedy”.
Figure 1: US consumer prices post largest annual advance since 1981
For one thing, the enacted rate hike of 0.25% in March (the first since December 2018) and the planned, “aggressive” half-point hikes that are expected to follow in the coming months according to Reuters reports, are very likely to prove insufficient, or “too little too late”, to bring inflation under control. What’s more, the Fed’s plan for the “Great Unwinding” of its $9 trillion balance sheet, is still unclear to say the least. According to recently released minutes from the central bank’s March meeting, top officials “generally agreed” on monthly wind downs of about $60 billion for Treasury securities and $35 billion for mortgage-backed securities. Once again, this might not be enough to curb inflation, but it could be more than enough to cause disruptions in the markets, especially if this pace is sustained.
The common denominator of these tightening plans, not just in the US but also in the Eurozone, is that they are targeting the wrong root cause. Unlike many past inflationary periods, this time, we are facing a supply problem and it has been in the pipeline for decades. As we already highlighted in our September 2021 issue of the InSights, this has been abundantly clear in the commodities market. ESG and “green” policies and years of underinvestment in exploration projects have culminated in the extreme shortages we face today and the record-high prices in the energy sector, as well as for copper and other industrial metals. This was a long and slow process and it is unlikely to be swiftly reversed, especially using the wrong tools. If anything, we could expect the situation to worsen, particularly if we factor in the “emergency” measures and “inflation relief” packages we now see from governments all over the world. From fuel tax cuts in the UK and energy subsidies in the Eurozone, to President Biden ordering the unprecedented release of the nation’s strategic oil reserves and allowing higher ethanol content in gas, it is clear that the “cures” presented so far are merely political solutions to an economic problem.
Figure 2: The Federal Reserve’s balance sheet expansion
The high prices for commodities reflect an imbalance of supply and demand. And, as we pointed out before, it is now not the demand side, but the supply side that is driving prices higher. Therefore, trying to solve a supply-side problem by further stimulating demand is clearly counterproductive. To bring prices down, either supply must be increased and/or demand must be curbed. However, the supply of raw materials cannot be increased at the push of a button. Years or decades can pass between the ”discovery” of new deposits and their extraction or mining.
Figure 3: Global Money Supply (GLMOSUPP Index, blue) vs MSCI World Index (MXWO, red)
A rough roadmap
One of the most important things that we feel investors must keep in mind going forward is that (at least) since the 2008 recession, stock markets have not been primarily driven by fundamentals, but by central bank policies. This is especially crucial now, as we stand on the verge of a great “U-turn” in these policies. After more than a decade of Quantitative Easing (QE) and ultra-low interest rates that fueled the record highs of equity markets, inflation is now finally forcing central banks to reverse their course. While it remains doubtful whether this pivot will have a meaningful impact on inflation and even if so, if it will come in time, there is a very strong possibility that it could cause serious turbulence in the markets and in the economy at large.
Specifically in the US, the Fed has been so far entirely focused on the second part of its “dual mandate” of “price stability and maximum sustainable employment”, in order to support the economy and the financial markets. This arguably came at the expense of price stability, which the central bank is now trying to control. With unemployment at record lows, inflationary pressures have now become more than just an economic challenge. With the midterm elections fast approaching, growing public discontent over climbing prices is emerging as a key political issue too, pilling on the pressure on the government and the Fed to take action, even if it is realistically insufficient.
We therefore expect the central bank to commit to this policy U-turn and to keep pursuing its price stability goal through QT and rate hikes, despite the risks this will pose for the markets and the economy. However, we believe these risks to be severe, given the “addiction” that stock markets in particular have developed to easing policies over the years. Additionally, the extreme corporate debt levels that the zero-interest environment has encouraged will likely become very problematic should the Fed stick to its planned rate hikes. The same can be said of consumer borrowing, which in February surged in the US by the most on record, a $41.8 billion jump from the month before. Overall, this tighter monetary policy direction is bound to put dangerous pressure on an economy that is rife with structural vulnerabilities and has had barely any time to recover from the unprecedented restrictions and disruptions of the pandemic.
As a result, the Fed’s tightening “U-turn” and the current focus on one part (price stability) of its mandate, will very likely lead to a deterioration in the second (the economic situation): as the economy slows down and eventually probably sinks into a recession, unemployment will once again emerge as the most urgent problem, forcing policy makers to perform yet another “U-turn”. Whether inflation will actually have been tamed by then, and to what extent, is highly debatable, but it will also be beside the point. At that stage, supporting the economy and the workforce will once more become the priority and a full return to QE and to low interest rates can be expected.
While we do expect a significant slowdown, and quite possibly even a recession, once this policy shift toward tightening really begins to have an impact on the real economy, it is practically impossible to predict its precise timing. We could start seeing indicators pointing to a recession even before the end of this year, but what is a lot more certain is that higher stock market volatility levels will characterize the next weeks and months.
We therefore believe that it is imperative for investors to understand that the coming quarters will not be fit for “buy and hold” strategies and will require great vigilance, agility and downside protection. Even if we are surprised by positive developments, such as a swift resolution to the Ukraine crisis, which would probably fuel a “relief rally”, we can expect this to be rather short-lived. As long as the inflationary pressures remain unchanged and as long as central banks retain their monetary tightening stance, stock markets will have a very hard time sustaining a rally or indeed the current levels.
Of course, none of this means that investors should turn their backs on equities. During this tightening period, we expect traditional defensive sectors to present good opportunities, while commodities could also offer an inflationary hedge, in the likely scenario that the central banks’ efforts will prove inadequate in controlling climbing prices.
Most importantly, however, we anticipate a roaring rally in stock markets once that second “U-turn” (the “U-turn” from the “U-turn”) is becoming apparent and once we return to the path of QE and we will see, most probably, massive fiscal stimulus. In the course of this development, the USD is also bound to suffer as the credibility of the Fed will be adversely impacted, while the overall political and economic climate will likely be quite negative too, both factors being supportive of a strong performance for gold.