We’ve experienced some interesting market moves since the beginning of this year. Most significantly, at least for those who have pensions and investments, has been the savage decline in equities, particularly those in the tech sector. After hitting its all-time high in November last year, the US NASDAQ 100 lost 34% of its value over the following seven months. It had a modest rally, but the index has since given back most of these gains and remains within spitting distance of its mid-June low. The last time we experienced such market carnage was back in early 2020 when the NASDAQ 100 fell 31% on the pandemic panic. But it did this in the space of one month, whereas the current sell-off has lasted considerably longer. This latest decline came as investors reacted to a sudden hawkish turn from central bankers who finally reacted to headline inflation numbers as they hit multi-decade highs. Led by the US Federal Reserve, developed world central banks had previously insisted that the post-pandemic pick-up in inflation was transitory in nature, suggesting there was no need for monetary tightening. The thinking went that the global economy would soon return to normality as supply disruptions were eliminated and supply and demand got back in kilter.
Monetary and fiscal stimulus
But that just hasn’t happened. The combined monetary and fiscal response to the government-imposed pandemic shut-down dramatically added to the stack of money already in the financial system. But rather than getting stuck in banks and other financial institutions as it had previously, this time round much of it went directly to individuals who were more than willing to spend it. Demand up; supply of goods constrained. Add in the Russian invasion of Ukraine and the resultant spike in energy prices and suddenly there’s a problem that even the economists at the Fed and Bank of England are forced to acknowledge.
Too late
Most governments give their central banks the job of controlling inflation with a target, mandated or otherwise, but in every case arbitrary, of around 2%. Having done everything in the book since the Great Financial Crisis to push inflation up to this level, central bankers have proved to be powerless to control it now that it has shot above target. All they can do is try to take some heat out of the economy, principally by raising interest rates. But having delayed tightening monetary policy for so long, now they are doing this as economic growth slows significantly following its post-pandemic surge higher. This has significant effects on the global economic outlook which is still getting priced into financial assets.
Bond yields slump
Perhaps the starkest example of this is yields on US Treasury notes which have pulled back substantially since mid-June. In early July both the yield on the 2 and 10-year notes were both around 2.80% and well below the 3.4-3.5% levels they hit in mid-June. This was just after the Federal Reserve hiked rates by 75 basis points and indicated that they would do the same in July. While we’ve seen a pick-up in yields since then, the pull-back suggests that investors expect the Federal Reserve to start cutting rates relatively soon, perhaps next year, as economic growth slows. The hope is that the Fed can engineer a soft landing and avoid a deep or long-lasting recession.
Incoming data
Next week sees the latest update on US CPI, the key inflation measure as far as investors are concerned, if not the Federal Reserve. Last month it hit 8.6%, its highest level in forty years. The concern is that it has yet to peak, which has forced the US central bank to undertake an unexpectedly aggressive pace of monetary tightening. This is having a devastating impact on equity and bond prices. But any indication that inflation has peaked, and that the Federal Reserve can ease up on raising rates could ease the downside pressure on equities. That’s why the central bank, and investors everywhere, are fixated on the release of every single scrap of inflation data.
And earnings
We also have the start of the second quarter earnings season which could be another headwind for asset prices. Key here will be forward guidance from companies. If the numbers are bad, but corporations say they can see a way forward, then we could get a bounce-back in stock prices. But without this, equities could continue to struggle.
