Eliminating the improbable
With a fresh surge of inflation increasingly unlikely, the market outlook is far better than it was a year ago
“WHEN you have eliminated all which is impossible,’‘ as Sherlock Holmes liked to say, “then all that remains, however improbable, must be the truth.”
After a global pandemic, a major European war and a Saudi Arabian defeat of Argentina in the 2022 World Cup, nothing seems impossible these days. The recent collapse of Silicon Valley Bank (SVB) and forced sale of Credit Suisse introduced even more uncertainties.
But investors can still eliminate the improbable, and then search hard for truth amid the jumble of what is left. This exercise suggests a difficult economy this year, but markets may just offer positive returns as they begin looking to 2024.
Will inflation rise from here?
On the list of improbables, rising global inflation ranks high. Yes, China’s reopening could drive oil and gas prices higher. Escalating violence in Ukraine might disrupt Russian exports and roil global commodities markets. A new strain of Covid-19 would surely trigger fresh turmoil in supply chains.
Still, it is hard to imagine the US consumer price index ending the year higher than the 6.4 per cent reported on Feb 14, following the sharpest set of Fed hikes in decades. Manufacturing indices from purchasing managers in Europe, the US and Japan all show slowing economies.
Meanwhile, supplies of everything, from semiconductors and shipping containers to workers, are returning mostly to normal. With the recent tightening of credit conditions, it is hard to paint a picture of prices running wild anytime soon.
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Are we on the verge of a sharp recession?
Given the global headwinds, depressing political headlines and the recent bank turmoil, recession hardly seems out of the question. But it still looks either more distant or less severe from the recent data. In the US, a strong jobs market continues to support healthy consumer spending, with January’s retail sales blazing in at 3 per cent higher than the previous month.
Elsewhere, Europe’s winter never came, helping to cushion the loss of Russian supplies, while governments offered subsidies that kept households spending. China’s sudden decision to lift most Covid restrictions may boost its growth this year significantly, enhancing global demand and making a sharp recession this year almost as unlikely today as runaway inflation.
Will the Fed soon declare victory over inflation?
Markets have been looking for the Fed’s pivot since inflation readings peaked last summer, and investors have been redefining the term from then on. Now, even the shift from a 50 basis point hike to 25 basis points gets an enthusiastic reaction from investors.
The recent Fed meeting suggested the hikes are nearing an end in light of recent events. But it also confirmed that the rate-setters are in no rush to cut. And with the ghost of Paul Volker haunting every member of the Federal Open Markets Committee, who among them wants to relax policy only to have inflation then tick higher the next month?
Will higher rates finally trigger an accident?
Interest rates that marched inexorably lower for four decades created possibilities for all kinds of new business models. But those days are gone, and investors are rightly bracing for the accidents that occur in every tightening cycle. Until last week, the surprises have either been well contained – such as the UK pension turmoil – or not entirely surprising, such as the upheaval in cryptocurrencies.
The Fed’s response to the closure of SVB, combined with the swift action by Swiss regulators, looks initially like they may calm broader fears, even if much remains unknown.
Stock sell-offs suggest that smaller, regional banks remain under suspicion because of their exposure to commercial real estate. But the largest banks still report solid balance sheets, making a financial detonation that morphs into a systemic crisis much less likely.
Will markets end the year below current levels?
Already this year, bond markets have changed their views on the prospects for recession at least twice. Stock prices have gyrated, too, although they look surprisingly resilient.
It is easy to say we will not repeat the dismal performance of last year’s returns for stocks and bonds. But the dissipation of uncertainty around inflation, growth and monetary policy should reduce market risk and raise the range for reasonable valuations. Another market slide from here does not seem likely to last.
And so, having excluded most of what is improbable, we are left with the possible, or even the likely.
Last year’s “stagflation shock” has evolved into something more like a “stagflation haze”. US growth will be lower than last year’s 2.1 per cent, but growth next year should be better than whatever we get this year.
Europe’s growth will definitely fall from 3.4 per cent in 2022, but the region may yet avoid recession. If inflation continues to fall – slowly but more or less steadily – then the economic outlook and risk markets look far more attractive currently than they did last year.
That is, as long as we avoid a shock on a par with a pandemic, an invasion, or an epic World Cup upset.
The writer is chief global strategist, Barings.
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