ECB is still printing money whereas the Fed and BoE have ceased cash creation
The US stock market briefly entered bear territory last month, defined as a fall of 20 per cent or more. Investors worry that inflation, racing ahead on both sides of the Atlantic, will get worse. Central banks have lost their magic and are struggling to catch up with reality, prompting fears that the cure for inflation will be worse than the affliction. As investors contemplate recession, the US market’s decline has been led by the great growth stocks and success stories of the past decade. The Nasdaq technology index, from which the FT fund exited after a great run, is now well into bear market territory with losses of more than a quarter. The broader indices, with old economy stocks including oil and gas, banking and some commodities, have fallen less. Some of these sectors can do well even in these disrupted conditions and provide a brake on the general decline. Two weeks ago we saw a rally.
People are beginning to doubt the wisdom of the central bankers who have made the long bull market possible with their accommodating ways. Why didn’t the governors of the US Federal Reserve and the European Central Bank grasp that printing too much money usually leads to too much inflation? US president Joe Biden met with Fed chair Jay Powell last week to remind him that the prime task of the Fed should be to do what it takes to get on top of inflation. It is high and rising prices are hurting the president and his party in the polls as Americans struggle with soaring rent, food and energy bills. In the regulated world of modern investment funds, managers have to watch out as their fund values fall; they need to keep their funds with the minimum investment levels specified to retain their ratings as growth or balanced portfolios. They may try to switch into more defensive assets, but need to keep enough share risk to justify the fund description.
This makes sense on the basis that bear phases are usually limited in time and magnitude, and that over most longer periods people should make money out of sensibly chosen riskier assets. So we need to explore what might change the downward trend of these gloomy markets. Can the recent rally be sustained? Whenever central banks threaten further rises in interest rates, it is difficult for markets to rise. Bonds fall because higher interest rates need lower bond prices. Many shares fall because companies face higher interest charges on their borrowings. This erodes profits, and may curb the demand for their goods and services as higher mortgage and credit costs squeeze family incomes. For as long as inflation remains on the rise or persistently high, it is likely the central banks will stick with their recently acquired hawkishness on rates, regretful that they did not do more last year to arrest growing inflation. That is why I kept the fund with substantial cash at around 25 per cent and ensured the bond section of the portfolio was in short dated and index linked paper. I have recently switched some of the money out of short dated US Treasury inflation linked into short dated corporate debt as the inflation story is now well known. The corporate bonds offer a bit more income now that rates have risen somewhat from the lows.
The position in Europe is different. Economies are closer to recession on this side of the Atlantic. Germany had a down quarter at the end of last year. While the US is still growing quickly, the European economies are stalling. The Ukraine war looms larger, the stimulus was less substantial and the growth rate slower anyway. The Bank of England was early in stopping money creation and bond buying, which has decelerated the money supply. The US has great strengths against the present poor outlook, with self sufficiency in gas, a lot of oil and plenty of homegrown grains. Europe in contrast has to import more at sky high and erratic world prices. Large increases in the cost of basics act like a big tax rise, hitting people and companies. The money they have to pay for energy and food means they have less to spend on other things. Quite a lot of the energy cost is tax, given away to the governments of the producing countries and so lost for domestic spending and output.
One of the oddities is the ECB has still not stopped printing more euros even though six member states in the euro have inflation rates above 10 per cent and the average is now 8.1 per cent.
I am watching to see when the forces creating a slowdown are sufficient to ease price pressures. When do the central banks and governments start to worry more about recession and less about inflation? It seems likely we will be through the rate rising cycle more quickly than gloomy markets currently assume, as the forces of slowdown are very considerable. We may now have seen growth in US prices and wages peak, which would be good news. If so, that will limit how high interest rates have to go. The Europeans may not be too hawkish with the rate rises being mentioned, as they have left it late to end their money creation and now have serious problems with output as well as prices to balance.
It is, however, still quite early in the shift from fighting inflation to offsetting recession. Labour markets are still stretched, capacity is still too low in many important areas and central banks are still smarting from their big mistakes last year in forecasting low inflation. It will take further cuts in demand to cool the prices of everything from bread to circuses. We are living through a bigger retreat from globalisation, which lowers efficiencies and raises prices. There are still people reluctant to return to the workforce keeping labour markets tight. The biggest change of all is the ending of extra dollar printing in the US, the termination of sterling creation by the BoE and the likely cessation of more euro printing by the ECB. This removes crucial supportive buying from the bond markets at a time when governments are still needing to sell plenty of debt.
Only Japan keeps pressing the keys for more yen as their inflation defies the winds that fan the price rises elsewhere. Markets are still adjusting to this bad news. They will return to winning ways when we can see an eventual peak to the rate rises and a clearer need for governments to make recession-fighting the priority over inflation. We may be getting closer to better news on falling inflation, with early signs of cooling in housing markets and even signs that wage increases are peaking. When the authorities see shortages easing, and margins being squeezed to keep prices down, markets will start to look beyond the bad news.