Great reversals in markets are now under way
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It is, on the face of it, a paradox. Markets in October were mired in pessimism as inflation remained stubbornly high and investors feared that central banks would keep policy interest rates higher for longer.
By December, those same markets were gripped by euphoria thanks to seemingly dovish statements on interest rates by Federal Reserve chair Jay Powell that appeared to promise earlier rate cuts than previously expected. And now in January, equity markets have made a rocky start to the year.
The key to understanding these extreme swings in sentiment is to be found in the mechanics of data dependent monetary policy. This causes investors to revise and re-revise endlessly their trading strategies based on intense parsing of central banking rhetoric and on expectations of how ageing incoming data of variable quality will influence central bankers’ rate setting.
Within this backward-looking, shaky policy framework, short-termism is endemic. And the risk is that markets overlook longer term fundamentals. That risk will be especially high in 2024, which will witness continuing reversals in longstanding economic trends.
Despite the markets’ cheery recent assumption about waning inflation, the protracted era of ultra-low interest rates is surely over. Yes, short-term rates will fall in 2024 as inflation continues to decline. But the longer term is another matter.
For a start the central banks’ commitment to shrink their balance sheets after the extended period of quantitative easing means that they will be withdrawing their buying power from public markets just as government borrowing requirements are running at peak levels.
A broader threat to the Panglossian “free lunch” view of government debt born of negligible real interest rates since the 2007-09 financial crisis relates to the reversal of several positive supply shocks to the world economy since the 1980s.
The most important concerns the impact of the rise of China and other emerging markets on the global labour market. This led to a glut of labour that depressed wages in the developed world. One result was reduced investment as companies substituted labour for capital, which helps explain the dismal productivity record since the crisis. Another was quiescent inflation (for which central bankers breezily took credit).
Yet now the global labour force is shrinking. Since the pandemic labour’s bargaining power has increased and will increase further as workforces go on shrinking in ageing advanced countries and also in China and Korea. The surge in wages now encourages companies to substitute capital for more costly labour.
Other economically benign effects of globalisation such as cross-border supply chains are being de-risked in the face of geopolitical confrontation. This brings resilience at the cost of economic efficiency. Meantime, protectionism is on the rise. All of which is dismal news for growth.
Harvard’s Kenneth Rogoff argues that even if inflation declines it will probably remain higher for the next decade than in the decade after the financial crisis. He cites factors including soaring debt levels, increased defence spending, the green transition and populist demands for income redistribution. Hard to argue with that, although there is an open question as to how far technologies such as artificial intelligence might offset these inflationary pressures.
Do not expect China to come to the rescue on either the growth or inflation front as it did after the financial crisis. Its former growth model, substantially driven by the property market, is structurally challenged now and China is expected henceforth to import less.
One of the most profound impacts from the reversal of ultra loose monetary policy turns on the profitability and finances of the corporate sector in the advanced countries. A study by the Fed’s Michael Smolyansky shows lower interest expenses and corporate tax rates explain more than 40 per cent of the real growth in corporate profits from 1989 to 2019 for S&P 500 non-financial firms.
That is an eye-catchingly large number and the picture will be similar across the developed world. In today’s fiscal bind, the scope for more corporate tax cuts is minimal and interest rates are not going back to near-zero. So prepare for a long-run slowdown in corporate profits growth and stock returns.
After these great reversals the new normal for investors will include a very challenging monetary landscape with heightened volatility and higher long bond yields than in recent years. Against a background of burgeoning public debt, stringent official interest rates now contribute to uncomfortably high government borrowing costs.
Political pressure on central banks may thus intensify. Meantime higher rates and bond yields in the no longer ultra-loose monetary regime will impose continuing strains on the financial system, putting the central banks’ goals of inflation control and financial stability potentially in conflict. It seems questionable whether market practitioners have taken all this toxic matter on board.