Market Update: Markets Bet on a Perfect Landing

The thought is that this will cause a reversal of central bank policy sooner than previously expected with implied US rates peaking by the end of this year. Investors have essentially given central banks – particularly the US Federal Reserve (Fed) – a vote of confidence. Its policies are expected to prevent a dangerous wage-price spiral while maintaining the economy at a decent level. What’s more, middle-class consumers still have considerable savings to fall back on, while jobs remain plentiful and businesses are more financially sound than in previous downturns. Recessions in most regions are expected to be shallow and brief, while the US might avoid one altogether.

The problem with this view is that it contradicts what central bankers themselves are saying. Fed Chair Jerome Powell’s speech last week was gained praise for its seemingly dovish tones, but he still committed to raising rates and crushing inflation at all costs. The disparity is even more apparent in the UK, where Bank of England Governor Andrew Bailey and his team issued warnings as dire as they come.

We suspect that the alarmist lingo is more a warning than a genuine prediction. Monetary policy works on a very long lag, meaning that tweaks to interest rates now will only have an effect a year or so down the line. But if bond markets are to be believed, inflation will already be largely under control by then – meaning further tightening would be overkill. Central bankers want to tame inflation right now, and the only way they can think to do that is by affecting consumer and business behaviour. They will hope that pessimism will stop employees pushing for higher wages, bringing down cost pressures.

That is the best-case scenario, and the one markets are currently betting on. Such optimism in bond markets was the main reason for July’s uptick in equity prices – as falling yields made stocks comparatively more attractive. But that positivity is itself a little concerning, as it makes asset prices vulnerable to worse-than-expected news.

There are still many risks to the overall outlook, which are arguably not properly priced-in. Europe is particularly at risk, facing energy shortages and sharply higher costs this winter. This should bring consumer demand down further and eventually cool inflation, but that could take some time. The main source of Europe’s woes is gas supplies, which are very hard to adjust in the short-term, and are highly susceptible to Russia’s war in Ukraine. European businesses could be the hardest hit, as they have less sway over electoral outcomes and are therefore lower down on politician priority lists.

Markets nevertheless seem to think the inflation battle is already won, and there is a clear path to economic recovery. But none of that is certain, and there are many political obstacles that could get in the way. Governmental paralysis in Britain and Italy could prevent decisive policy action (Conservative MPs have already questioned the Bank of England’s independence in response to its dire forecasts), while US-China tensions over Taiwan are a serious and perhaps under- appreciated risk to global growth. Negative news flow, particularly around energy supplies, could severely dampen market sentiment.

At the same time, the huge uncertainty around energy means things could turn out better than currently expected. Elevated gas prices in Europe have become the main concern to the global outlook, but there is very little information on when they might subside. Since it is purely a supply-side issue, we know that it will not last forever (as US gas costs are a fraction of Europe’s) but is just a question of how long.