The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
For years, financial markets benefited enormously from the generosity of monetary policy in a world economy deemed by central banks, and the US Federal Reserve in particular, to lack sufficient aggregate demand.
To the detriment of markets, this has been changing rapidly as central banks belatedly recognize that today’s problem is not one of weak demand but, rather, insufficient supply. Looking forward, an even more complicated possibility is taking shape: that of stalling demand in the midst of persistent supply disruptions.
Central banks felt compelled to maintain ultra-loose monetary policy in a world of muted economic growth and deflation risks. The Fed went further and, in August 2020, shifted to a new monetary framework that postponed the usual policy response to inflation nearing and exceeding the Fed’s 2 per cent target.
For markets, this translated into abundant liquidity. The surge higher in asset prices due to ultra-low interest rates was turbocharged by regular injection of funds by the Fed through massive, predictable and price-insensitive purchases of assets.
All this has been coming to an end due to the threat to economic wellbeing posed by high and persistent inflation. The cause has been the dramatic change in the macroeconomic paradigm to one in which damaged supply disruption, due primarily to supply chains and labor market tightness, has fallen well short of overstimulated demand.
In such a world, the Fed has no choice but to take its foot off the stimulus accelerator. And as it is very late in doing so, it will need to move aggressively in hitting the brakes, including by “front-end loading” rate increases as it simultaneously starts to reduce a bloated balance sheet that expanded to a staggering $9tn. The risk of recession associated with this is unsettling.
Unsurprisingly, markets have not enjoyed the change in the Fed’s approach as illustrated by the sell-off in stocks and other risk assets, including 13.3 per cent fall in April alone for the more interest rate sensitive growth stocks of Nasdaq.
This regime change has been made even more painful for investors by the breakdown of traditional “havens” as government bond prices fall and the real return on cash holdings drops deep into negative territory due to 8.5 per cent US inflation.
Until now, rising inflation has fortunately not been accompanied by a significant worsening of credit risk or large problems in market-functioning. However, this could well change if demand fails. Already, the prospect of “stagflation” (lower growth and high inflation) is transitioning from a risk to a “baseline” scenario for several reasons.
The US is looking at an accelerating erosion in both monetary and fiscal drivers of growth and financial asset valuations. Policymakers will need a rare mix of skill, luck and time to soft land both an economy and markets conditioned by once-unthinkable levels of policy stimulus.
Meanwhile, household confidence and purchasing power are being eroded by inflation at a time when the high level of savings that was boosted by stimulus programs is being run down.
The external headwinds are also a worry. China’s stubborn adherence to a “zero-Covid” policy in the midst of the highly infectious Omicron variant is undermining both its global supply and demand roles. Europe is also slowing down and could well fall into recession should there be a major disruption in gas supply due to the war in Ukraine. Meanwhile, several commodity-importing developing countries are facing the disruptive mix of high food and energy prices, supply uncertainties, tightening financial conditions and an appreciating dollar.
The stronger such headwinds become, the bigger the risk of a general financial deleveraging that affects the functioning of markets. Corporate earnings and labor market strength will be key for investors to watch as offsets to these trends.
The good news is that, after years of massive distortions, financial markets are correcting to levels where there is more sustainable value. There is also the prospect of the restoration of more traditional correlations in markets. That will bolster the risk-mitigating characteristics of diversified investment portfolios.
The bad news is that the transition from the prior paradigm of central bank policies is not complete. With the potential coincidence of both demand and supply complications, markets are likely to remain volatile for investors and more unsettling for the real economy.