Opinion: Four fairy tales stock market investors and economic policymakers tell each other
LONDON (Project Syndicate)—Do you believe in fairy tales? If so, you could probably make a lot of money these days as a financial trader or gain power and prestige as a central banker.
With annual inflation in the US, eurozone and UK hitting 40-year highs and likely to hit double digits after the summer, financial markets and central banks appear confident that war against soaring prices will be over by Christmas and interest rates will start falling next spring.
Everything is fine
If that happens, the global economy will soon return to the financially perfect Goldenilocks fairy tale conditions that have fascinated investors for the past decade: neither too hot nor too cold, and still just for profits.
“ The question is whether the new era that is dawning will be dominated, for the first time in a generation, by sustained rapid price growth; or if, for the first time in history, we will painlessly overcome an inflationary crisis with negative real interest rates and without the collateral damage of a major recession.”
Investor optimism can be seen in the trillions of dollars recently bet on three closely related market bets. Money markets now predict that US interest rates FF00,
will peak at less than 3.5% in January 2023, then decline from next April to around 2.5% in early 2024. Bond Markets TMUBMUSD10Y,
are priced for US inflation to plummet from 9.1% today to just 2.8% in December 2023. And SPX Stock Markets,
assume that the economic slowdown driving this unprecedented disinflation will be moderate enough for US corporate profits to rise 9% in 2023 from this year’s record highs.
Central bankers are more nervous than investors, but they are reassured by their economic models, which are still based on updated versions of the “rational expectations hypothesis” that failed so miserably in the 2008 global financial crisis. These models assume that expectations low inflation are the key to maintaining price stability. Central bankers therefore see “well-anchored” inflation expectations as proof that their policies are working.
When central bankers and markets come and go, both are susceptible to being misled. But that only partly explains the willingness of financial markets to bet against the warnings of prominent commentators such as Larry Summers, Mohamed El-Erian, Jim O’Neill and Nouriel Roubini of a return to stagflation in the manner of the 1970s.
Buy to the sound of guns
I just spent three months traveling the world talking to hundreds of professional investors about why I too have adopted a clearly bearish outlook, after a decade of Panglossian optimism about the outlook for financial markets. These discussions have convinced me that today’s investor confidence is based on four errors, or at least cognitive biases.
The first cognitive bias is to downplay and challenge geopolitics – a view encapsulated in Nathan Rothschild’s legendary instruction in the Napoleonic Wars to “buy at the sound of guns”. Professional investors take pride in trading against panicked retail investors who sell their assets because of wars.
This contrary approach has often been proven correct, but with one glaring exception. The October 1973 war between Israel and a coalition of Arab states led by Egypt and Syria permanently transformed the global economy in ways that ruined a generation of overconfident investors. They downplayed events eerily reminiscent of today: an energy shock, a surge in inflation after a long period of monetary and fiscal expansion, and the perplexity of policymakers confronted simultaneously with high inflation and a rise in unemployment.
Hugging Russia, one of the world’s largest CL00 energy producers,
and many other commodities, out of world markets has triggered a supply shock that is at least as severe as the Arab oil embargo of 1973-74 and will last for years. Restoring price stability will therefore now require a long-term demand constraint strong enough to match the reduction in the supply of commodities. This implies an increase in US interest rates to 5%, 6% or 7% instead of the 3.4% peak that investors and central banks are now assuming. Yet investors’ Pavlovian reflex is to downplay this geopolitical upheaval and instead focus on small adjustments to US monetary policy.
The trend is your friend
This position reflects a second cognitive bias, summed up in the investment adage “the trend is your friend”, which implies that changes in market-moving economic indicators such as inflation, unemployment or interest rates are more important than their levels.
Many investors therefore believe that monetary conditions have become very tight because central banks have raised interest rates in increments of 0.75 percentage points instead of the usual 0.25 percentage points, despite the fact that rates are still well below any previous tightening cycle.
Similarly, investors do not seem bothered by inflation above 9% as they expect it to fall to “only” 7% by December. But businesses and workers in the real economy will still see prices rise at their fastest pace in decades, which is sure to boost corporate pricing strategies and wage negotiations for 2023.
Don’t fight the Fed
Such a conclusion seems obvious, except for financial traders subject to a third cognitive bias: “Don’t fight the Fed”. This favorite market saying says that once the US central bank takes seriously achieving a goal, such as an inflation target, investors should always assume that it will get what it wants.
It makes sense when the Fed is genuinely prepared to do whatever it takes to achieve its goals, such as clearly pursuing low inflation, regardless of the effect on unemployment, stock markets and service costs. debt. But today’s Fed is so focused on “well-anchored” inflation expectations that it’s quite relaxed on “retrospective” data that continues to show prices rising much faster than most companies and workers have never seen.
Nothing new under the sun
This leads to a final bias: most people have trouble imagining events that have never happened in their lifetime. For many investors and policymakers, stubbornly high inflation falls into this category. Market wisdom expresses this bias with the adage that “there are no new eras”.
But new eras are coming, as the world painfully learned in 1973. And the current interaction of Russia and COVID-19 with monetary and fiscal expansion has created unprecedented conditions, which ensure that the period future will be very different from the past 40 years.
The question is whether the new era that is dawning will be dominated, for the first time in a generation, by sustained rapid price growth; or if, for the first time in history, we will painlessly overcome an inflationary crisis with negative real interest rates and without the collateral damage of a major recession. Markets and central banks are confidently anticipating a carefree new era. If they’re right, we can all live happily ever after.
Anatole Kaletsky, chief economist and co-president of Gavekal Dragonomics, is the author of “Capitalism 4.0: The Birth of a New Economy in the Aftermath of Crisis” (Public Affairs, 2011).
This commentary is courtesy of Project Syndicate — Why are financial markets so complacent?
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