LONDON (Project Syndicate) – Do you believe in fairy tales? If so, you could probably earn well as a financial trader or gain power and prestige as a central banker nowadays.
While annual inflation in the US, eurozone and UK has risen to 40-year highs and is likely to reach double digits after the summer, financial markets and central banks seem confident that the war against the price hikes will end by Christmas and that interest rates will begin to fall by next spring.
Everything is right
If that happens, the world economy will soon return to the financially perfect condition of the Goldilocks fairytale that has enthralled investors over the past decade: neither too hot nor too cold and always right for profits.
“ The question is whether the new era that is dawning will be dominated, for the first time in a generation, by constantly rapid price growth; or whether, 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 severe recession.“
Investor optimism can be seen in the trillions of dollars recently wagered on three closely related market bets. Money markets now predict that US interest rates FF00,
it will peak below 3.5% in January 2023 and then decrease from next April to around 2.5% at the beginning of 2024. Bond Markets TMUBMUSD10Y,
US inflation is expected to drop from 9.1% today to just 2.8% in December 2023. And the SPX equity markets,
we assume that the economic slowdown causing this unprecedented disinflation will be mild enough to allow US corporate profits to increase 9% in 2023 from record levels this year.
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. expectations of 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 follow each other, both are likely to go astray. But that only partially explains the willingness of the financial markets to bet against the warnings of eminent commentators like Larry Summers, Mohamed El-Erian, Jim O’Neill and Nouriel Roubini of a return to 1970s-style stagflation.
Buy with cannons
I just spent three months traveling the world discussing with hundreds of professional investors why I also switched to an unequivocally bearish outlook after a decade of Panglossian optimism about the financial market outlook. 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 point of view summed up by Nathan Rothschild’s legendary instructions in the Napoleonic Wars to “buy with guns.” Professional investors take pride in trading against panicked retail investors who sell their assets due to wars.
This contrarian approach has often proved correct, albeit with one obvious exception. The October 1973 war between Israel and a coalition of Arab states led by Egypt and Syria permanently transformed the world economy in ways that ruined a generation of overconfident investors. They downplayed events that are strangely reminiscent of the present day: an energy shock, a surge in inflation after a long period of monetary and fiscal expansion, and bewilderment among policymakers who faced high inflation and rising unemployment at the same time.
Squeezing Russia, one of the world’s largest producers of CL00 energy,
and many other commodities outside global markets triggered a supply shock that is at least as severe as the 1973-74 Arab oil embargo and will last for years. Therefore, the restoration of price stability will now require a long-term demand constraint that is strong enough to match the reduction in the supply of raw materials. This implies a rise in US interest rates to 5%, 6%, or 7% instead of the 3.4% spike that investors and central banks now speculate. However, the Pavlovian reflex of investors is to downplay this geopolitical upheaval and instead focus on small adjustments in US monetary policy.
Trend is your friend
This stance reflects a second cognitive bias, summed up in the investment adage “the trend is your friend”, which implies this. changes in the market, economic indicators such as inflation, unemployment or interest rates are more important than theirs levels.
As a result, many investors believe that monetary conditions have become very tight as central banks have raised interest rates by 0.75 percentage point increases instead of the usual 0.25 percentage point, despite the rates being still much lower than to any previous tightening cycle.
Likewise, investors do not seem troubled by the rise in inflation above 9% because they expect it to drop to “only” 7% by December. But businesses and workers in the real economy will still see prices rise at the fastest pace in decades, which is set to drive companies’ pricing strategies and pay for negotiations for 2023.
Don’t fight the Fed
Such a conclusion seems obvious, except for financial traders prone to a third cognitive bias: “Don’t fight the Fed.” This preferred market saying states that once the US central bank takes achieving a goal seriously, such as an inflation target, investors should always assume it will get what it wants.
This makes sense when the Fed is truly ready to do whatever it takes to achieve its goals, such as clearly pursuing low inflation regardless of the effect on unemployment, equity markets and debt service costs. But today’s Fed is so focused on “well anchored” inflation expectations that it is relaxed enough about “backstory” data that continues to show that prices are rising much faster than most businesses and workers have ever seen. .
Nothing new under the sun
This leads to one final bias: Most people have a hard time imagining events that have never happened in their life. 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 epochs are happening, as the world painfully learned in 1973. And today’s interaction of Russia and COVID-19 with monetary and fiscal expansion has created unprecedented conditions, which guarantee that the period ahead will be very different from the last 40 years.
The question is whether the new era that is dawning will be dominated, for the first time in a generation, by constantly rapid price growth; or whether, 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 severe recession. Markets and central banks are confidently looking forward to a new carefree era. If they are right, we can all live happily ever after.
Anatole Kaletsky, chief economist and co-chair 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 comment has been posted with permission from Project Syndicate – Why Are Financial Markets So Complacent?
More on the market and the economy
Nouriel Roubini: The shares could fall by 50%. Things will get a lot worse before they get better.
Joseph Stiglitz: How an arrogant and pathological America could lose the new cold war
Mohamed El-Erian: People in the global attic should worry about “little fires everywhere” in the basement