The world is still reeling from the effects of the pandemic, and the largely untested measures that the world’s governments and central banks applied to deal with it. Such measures may have been effective and necessary at the time, but we are now suffering from their aftermath: inflation, exacerbated by war in Europe.
With inflation continuing to rise, central banks need to raise interest rates further. Few would take issue with that. But the challenge lies in maintaining realistic levels of global growth while at the same time dampening down inflationary pressures. And care needs to be taken not to put too much pressure on consumers at a time when average household costs are soaring, driven by increases in energy and food prices.
The resignation of Italian Prime Minister Mario Draghi in the wake of the collapse of his national unity government has plunged the country into political turmoil. This has added pressure to the European bourses just as ECB president Christine Lagarde brought an end to eight years of negative European interest rates: the key interest rate was hiked from -0.5 percentage points to 0.0% – somewhat more than what was expected.
This aggressive increase comes at a time when the European Central Bank is trying to grapple with inflation that has surged to more than four times its 2.0% target rate. Meanwhile, the threat of recession is looming. And the recent slump in the value of the euro (it has reached parity with the US dollar for the first time in 20 years) is adding even more inflationary pressures to the eurozone.
The ECB has hinted that there could well be further interest rate rises in the offing but gave little guidance on the size of any such increases. It also unveiled its new Transmission Protection Instrument (TPI), designed to calm turmoil in the bond market amid concerns over a possible future eurozone debt crisis.
Unlike the US Federal Reserve Bank, whose decisions on credit are generally refracted through markets, the ECB has to contend with a more fragile banking system. That can be a problem – Europe’s banks have been far weaker than those of the US ever since the Global Financial Crisis.
Here in the UK, inflation has once again hit a new 40-year high. It now stands at 9.4% at a time when the cost-of-living crisis is hitting consumers harder than ever. The most significant contributors to this rise are fuel and food, with the former having risen by more than 42% in the year to June.
While the Bank of England has so far implemented five consecutive 25-basis point interest rate hikes, Governor Andrew Bailey indicated in his annual Mansion House speech that the Monetary Policy Committee is contemplating a 50-basis point hike at its August policy meeting. This would be the UK's biggest single hike for nearly 30 years – supporting the Governor's commitment to bringing inflation back down to its 2% target rate. To put this into perspective, the current inflationary conundrum is the largest challenge that the Bank of England’s monetary policy regime has faced in the quarter of a century since the Monetary Policy Committee (MPC) was created in 1997.
Switching from economics to politics, we now know that Liz Truss will face Rishi Sunak in the final round of the Tory party leadership contest. As is the case in Italy, the race for the premiership is being played out at a time when the UK economy is being buffeted by numerous headwinds: inflation, falling GDP growth and sterling that is at a two-year low against the US dollar. Meanwhile, many now believe recession to be imminent and bitter disagreements remain over the Northern Ireland Protocol.
Inflation is still troubling the economy on the other side of the Atlantic as well, impacting the bond market and creating periods of deepening yield curve inversion in sections of the US Treasury market. Its currency, on the other hand, has hit a fresh 20-year high against a basket of leading global currencies. This is certain to lead to further interest-rate hikes over the coming months.
The US Futures market is now indicating that there may be rate cuts by 2025. This suggests that the US economy might struggle with rising interest rates at a particularly delicate time: the Federal Reserve Bank might even ultimately be compelled to cut interest rates again.
It has long been acknowledged that the stock markets and the global economy are two quite different entities– albeit entities that are affected by the same global events. Right now, a plethora of negative factors is affecting both, souring the outlook for the global economy. Wall Street, for example – the largest stock market in the world – has just recorded its worst start to a calendar year since 1970. And with corporate earnings and an interest rate outlook that signals the potential for more downside risk, things do indeed look bleak.
Nevertheless, there are some signs that the equity markets may be bottoming out. On Wall Street, the S&P 500 Index hit a recent low of 3,666.77 in mid-June. In March 2009, that same index bottomed out at 666. And in March 2020… at 2,304. At present, that same index is 9% above the recent bottom that it hit in June 2022.
Unfortunately, inflation now appears very much to have been let loose: the central banks are chasing their tails, making all their usual central bank monetary policy errors in their manic determination to tame it. Further east, there is little sign of the Russia-Ukraine war abating any time soon and supply chain bottlenecks persist.
We are, however, seeing the prices of some materials and commodities beginning to fall. And inflation should soon start to reflect these decreases. The global events of the past couple of decades have been by turns rewarding and ungratifying – the pendulum swings back and forth between euphoria and despondency.
We continue to believe that in times such as these, the opportunities created by the recent falls we have seen in financial markets and asset classes should be embraced. Just look at the S&P 500 Index to get an idea of the investment returns that can be enjoyed from long-term investing – for those who are brave and tenacious… and able to hold their nerve.
