The National - Have central banks left it too late to tame inflation?

Vijay Valecha, Special to The National May 05, 2022

There is a massive shadow hanging over global stock markets right now and it is not the war in Ukraine. Nor is it post-coronavirus supply shortages or the impact of strict Chinese Covid-19 lockdowns.

The big worry for investors is how will central banks, especially the US Federal Reserve, react to the steep increase in inflation?

If our monetary masters turn belatedly hawkish and start ramping up interest rates, as many now expect, the stock market could come crashing down. The signs are this is already happening.

The US S&P 500 is down 10.61 per cent this year while the Euro Stoxx 50 is down 11.89 per cent. Technology stocks are bearing the brunt of the panic, with the Nasdaq crashing 19.71 per cent so far in 2022.

This could only be the start if Fed chair Jerome Powell serves up a 0.5 per cent interest rate increase in May, as most analysts now expect, and follows up with another 0.75 per cent uplift both in June and July, as pessimists fear.

That would push the Fed funds rate to between 2.25 per cent and 2.5 per cent, up from today’s 0.25 per cent to 0.5 per cent range.

After 13 years, the era of near-zero interest rates will have drawn to a sudden close and the impact will be fierce.

Higher interest rates make it more expensive for businesses and consumers to borrow money, which squeezes their spending power and slows the economy.

Another danger is that cheap money has fuelled bubbles everywhere, including share and property prices, cryptocurrencies, non-fungible tokens and other fads. This may now burst.

Central banks are on a tightrope and it is their own fault as they spent most of 2021 dismissing inflation as “transitory”. They are not dismissive now, with US inflation hitting a 40-year high of 8.5 per cent in March, driven by rising food and fuel prices.

Central bankers have been “significantly behind the curve” on inflation, says David Jones, chief market strategist at Capital.com.

Key commodities such as oil, gas, cotton and soya beans have been rising for the past two years, with no sign of slowing, he says.

“Higher inflation is not going away anytime soon.”

Central banks somehow have to raise rates to cap inflation, without throttling the economy. “The danger is they now overreact and put major economies at risk of recession,” Mr Jones says.

That explains this year’s stock market volatility, he says. “Nobody is sure how this will play out.”

He numbers among the pessimists. “I think they have left it too late and will overreact. Today’s stock market volatility is set to last for months.”

By leaving it late, central banks have increased the risk of policy error, where the medicine needed to fight inflation overpowers the global economy, says Guilhem Savry, head of global macro at asset manager Unigestion.

The stakes are high because if inflation beds in, it will be damaging and painful.

“It could trigger social instability due to negative real incomes. High inflation also acts as a tax, creating stock market turmoil,” Mr Savry says.

He expects an “aggressive first round of hiking to quickly curb inflation expectations” to show the world that central banks finally mean business.

“Doing nothing risks damaging the credibility of central banks to keep inflation stable.”

But they will quickly reverse rate increases if the global economy slows too much, he says.

The last time central banks drove up interest rates to curb inflation was in the early 1980s, when the Fed board led by Paul Volcker raised the federal funds rate from 11.2 per cent in 1979 to an eye-watering 20 per cent in June 1981.

In those days, the concept of negative interest rates was unthinkable, much in the same way as 20 per cent rates are unthinkable today, David Morrison, senior market analyst at Trade Nation, says.

“As was the prospect of central banks buying up bonds and other financial assets,” he says.

In Mr Volcker’s time, interest rates were higher than inflation, also unthinkable.

“With inflation at 8.5 per cent and interest rates at 0.5 per cent, the US currently has a negative interest rate of 8 per cent,” Mr Morrison says.

There is a growing feeling that the Fed has messed up again. While consumer prices seemed low by standard measures, the evidence of rising inflation was everywhere.

“Soaring equity markets, bonds, real estate, artworks, jewellery, classic cars and other asset classes all testified to credit that was just too cheap,” Mr Morrison says.

The Fed did attempt to tighten in December 2014, tapering stimulus and lifting rates from 0.25 per cent to 2.5 per cent over the next three years.

Stock markets slumped in what was labelled the “taper tantrum”.

“The Fed quickly reversed course and then delivered further monetary stimulus in response to the pandemic,” Mr Morrison says.

On top of this, the US government spent a staggering $5.2 trillion on Covid-19 stimulus, further turbocharging the economy and today’s inflation.

The Fed was in denial with its transitory line and now has to prove it is alert to the threat, Mr Morrison says. “That is why investors are freaking out.”

Yet, he is in the optimist camp.

“If the Fed aggressively lifts lending rates to 2.5 per cent over the next three months, there is a risk of crashing the market and causing a recession. I think the Fed will raise aggressively in May, then slow. When investors realise this, we should see stock markets recover,” Mr Morrison says.

Increasing interest rates is a blunt weapon. It will do nothing to ease supply chain shortages or stop the Ukraine war from driving up oil prices, but that is not what is worrying central banks, Laith Khalaf, head of investment analysis at AJ Bell, says.

“They are worried that inflation expectations risk becoming embedded in the system as workers demand higher wage settlements,” he says.

That explains why the Fed and Bank of England are talking a more aggressive game on rates, while the European Central Bank has been more cautious because eurozone wage growth has been more modest, he says.

With central bankers walking a tightrope, investors should resist the temptation to leap one way or another, Mr Khalaf says.

“Taking a heavy directional bet at the moment could leave your portfolio looking like a hero or a zero. The best advice is to keep your balance by diversifying across a mix of shares, bonds, cash, commodities, property and gold, covering different regions and sectors of the market,” he suggests.

Vijay Valecha, chief investment officer at Dubai-based Century Financial Brokers, says 2022 is turning into the opposite of 2021.

“Last year, quantitative easing and zero interest rates were tailwinds for a major stock market rally. Now, quantitative tightening and interest rate hikes are acting as a headwind,” he says.

Investors are abandoning “risk assets” as a result, particularly growth and technology stocks. Hence the sell-off in Big Tech in the US, where jumpy investors are taking fright at any sign of weakness, as is the case with Netflix, whose share price is down 66.6 per cent this year.

Other technology titans are also on the ropes, with Facebook (now Meta) down 39.23 per cent, Google owner Alphabet falling 18.26 per cent and Amazon dropping 15.15 per cent.

Microsoft (down 13.48 per cent) and Apple (a 10.19 per cent drop) are also battling those headwinds.

So-called value stocks, companies with steady revenue and dividends that have been overlooked by investors, are swinging back into fashion.

Mr Valecha tips two low-cost exchange-traded funds (ETFs) to play this trend. The Vanguard Value ETF and iShares MSCI USA Value Factor ETF are both up around 15 per cent over the past 12 months, although down slightly so far this year.

Mr Valecha is not too gloomy, as higher interest rates are now partly priced into investor expectations.

“After a big rate move, say, of 1 per cent, the stock market tends to stabilise and equity returns tend to be good after that point,” he says.

If he is right, those cut-price tech stocks may soon look like bargains for investors willing to take on a bit of risk right now.

There is one likely winner as interest rates rise and inflation fears slow, Mr Savry says. The US dollar is strong and set to become stronger.

“US assets should outperform the rest of the world, thanks to the robustness of the US economy and greater flexibility in the policy mix,” he says.

Right now, the Fed is ready to increase rates. But recent history shows it will cut them just as quickly if the initial medicine works. We will soon see.