The positive direction of stock markets at the start of the year was always at odds with the battle against inflation, it felt false. We thought that the market could test the lows of last year if a recession in the US occurred which now seems more likely given the obsession central banks have at hitting an empirical 2% inflation target, an inflation created due to the obvious mistakes they made in their reaction to the Pandemic.
To bring down inflation central banks want to see fewer people returning to work and consumers spending less, the complete opposite of what is required to improve the profitability of companies. Having reduced interest rates unnecessarily they are now recognising the fact and are making the mistake of raising them back up again too far and too quickly. They seem to be ignoring the fact that this current wave of inflation was created more by a lack of supply than consumer demand, albeit having been locked down for two years people unsurprisingly decided to splash out when they were allowed to. Inflation remains stubbornly high particularly in the UK and actually went up recently, but this was largely caused by a lack of supply of fruit and vegetables due to adverse weather conditions, not because everyone had a sudden desire to eat more greens.
The consequences of central banks raising interest rates can be seen from the recent demise of several banks. This is unlike the banking crisis of 2008. Banks are far better capitalised and so far the distress has been found in banks who have specialised in specific areas and whose management has made poor decisions. But ultimately they have been brought down by the rise in interest rates. Yet central banks continue to keep raising rates.
So how does this play out? Morgan Stanley strategist, Michael Wilson, says bank stress signals Bear Market end. Michael is one of Wall Street’s staunchest bears and predicts things might get worse before they get better. “This is exactly how bear markets end, an unforeseen catalyst that is obvious in hindsight, forces market participants to acknowledge what has been right in front of them the whole time.”
But dropping out of the market to avoid any potential volatility is also a mistake. “If you miss out on the start of the rally, you miss out on the bulk of the returns”, says Wylie Tollette, CIO of Franklin Templeton Investment Management.
The biggest fear for trillion-dollar funds is missing the next rally. The world’s biggest investors are looking beyond interest rate hikes, bank failures and recession. The financial instability created by the recent bank failures are the cues to speed up preparations. They are convinced that interest rate hikes will come to an end sooner rather than later and that interest rates could even fall.
Tollette is equally bullish on fixed interest. “Fixed Income is back. The danger of holding too few bonds when the Fed pivots sparks a rally outweighs any near-term depreciation on direction of rates or bank default fears.” His biggest fear is not that yields go up a little further from here, but the fear of being out of the market when the tide turns.
Goldman Sachs predicts UK inflation will fall below 2% by year end. This is partly based on lower energy costs but also a result of natural decline in the inflation statistics as supply issues are resolved. Markets will move positively before central banks confirm inflation is under control or that rates have ceased rising.
We are nearly there. Bear markets on average run for 18 months. Terry Smith of Fundsmith predicted the end of the Bear market this autumn at his AGM before the recent banking crisis occurred. The best place to hold your money is in a diversified portfolio of well managed businesses with little debt and good future profitability and wait to break out through the clouds into the blue sky ahead. We’ve been here before and we will be here again, it is what markets do. We are nearly there.
An article by James Scott-Hopkins, Managing Director, Irongate
The article is not intended to be a recommendation to buy. The value of investments can fall as well as rise.