To The Moon

US equities rebounded by more than 6 per cent in a shortened trading week. Interest rates are falling on the basis of a lower growth scenario (recession) and shares rose sharply nonetheless. A basket of non-profitable tech stocks even rose by 22 per cent last week. The probability of a recession in the United States has increased, according to economists, also helped by Powell's determination to fight inflation in his remarks to the US Congress. The increased likelihood of a recession is used as an explanation for the stock market recovery, but the move is much more a counter-reaction to a long period of rising interest rates and falling stock markets. As a result, sentiment had fallen to an extreme low (see Bank of America's Bull & Bear indicator, a combination of various sentiment indicators) and, just as a correction in an upward phase is often little more than letting off steam because the stock market has got a bit too far ahead of its fundamentals, the price drop since April was so sharp that it is now being met with a counter-reaction.

The only problem is that the fundamentals have not improved. The likelihood of a recession is overestimated, but the problems of inflation are underestimated. If there is to be a recession, it is likely to be so modest that it will not combat inflation. The 1970s showed that a combination of rising inflation and multiple recessions is quite possible. The Federal Reserve can reduce demand with higher interest rates, but it cannot solve the many problems on the supply side (shortage of raw materials, many job vacancies, problems with supply). The real problem is that inflation is so high that the central bank has to intervene unusually hard, and it remains to be seen whether it will come to that; Powell's words do not yet point to action in this respect. For bonds, in particular, sustained high inflation is bad news and the recent decline in interest rates is therefore completely unjustified. Shares offer better protection against inflation. They are mainly hit in the valuation as a result of higher inflation with, in turn, inevitably higher interest rates. It is possible that a large part of this downward valuation is already behind us, certainly for quality companies that can show in the coming months that they can meet or exceed expectations.

The structurally higher inflation worldwide creates a dilemma. A country can choose to accept this higher inflation or, instead, suppress inflation by means of monetary and fiscal policy. At the current high inflation rate, this cannot be done without a severe recession. Not every country will make the same choice and that will make a big difference to the ultimate return on investments in the years to come. Discipline will be rewarded. Unfortunately, the ECB has much less room to choose, given the differences in the eurozone. The bank seems to want to solve this with an anti-fragmentation rule that prevents interest rates from rising too fast in, say, Italy (but not in the rest of the eurozone), but it remains to be seen how the rest of Europe (including the German court in Karlsruhe) views this form of monetary financing.

Many investors are stuck in the mindset of the past decades, the many years of disinflation. Then there was always a Fed put, but the US central bank has no room for manoeuvre because of inflation. Because of the Fed put, there was no point in going against the Fed all those years, now it is different. Now the Fed does not even have the inflation curve in sight. Even after the explanation before the US Congress, a picture emerges that the Fed indeed has no idea where inflation is heading. The Fed was wrong about the temporary nature and the latest rate hikes show time and again that the Fed has no choice but to react to short-term developments, a horizon that extends to a week. The Fed will probably be able to give more leeway when inflation falls below four per cent. Given current wage inflation (which is actually true core inflation and is much higher), this is unlikely to happen for some time. Despite all the interest rate hikes planned for the coming year, this means that real interest rates in the United States are still negative, i.e. that monetary policy is stimulative. Investors may be tempted to say that all interest rate hikes have been discounted, but the combination of weakening macroeconomic news in the coming quarters and declining liquidity is not favourable. In the meantime, inflation remains high. If the Fed realises in a year's time that inflation is still well above 2 per cent, Powell à-la Paul-Volcker may want to crack down, but there is a chance that political pressure will push up inflation targets. At this point, it is not clear which choice the Fed (and US politics) will make (accept higher inflation or push for a deep recession), but until then financial markets will remain unstable.

For a long time, the adage 'Don't fight the Fed' worked. As long as the Fed was busy keeping interest rates low and US asset prices high, the Fed was your friend. That is over this year. High inflation means the Fed no longer has room to manoeuvre to please investors. On the contrary, high inflation means the Fed will have to raise interest rates further. The old scenario where the central bank indicated well in advance where interest rates were heading has been exchanged for a scenario where the central bank has no idea where inflation (and therefore interest rates) are heading.