LONDON (project syndicate)— Do you believe in fairy tales? Then you could probably make good money today as a financial trader or rise to power and prestige as a central banker.
While annual inflation in the United States, the eurozone and the United Kingdom has risen to 40-year highs and is likely to hit double digits after the summer, financial markets and central banks have seem confident that the fight against rising prices will be over by Christmas and that interest rates will start falling from next spring.
Everything is correct
If that happens, the global economy will soon return to the financially perfect Goldilocks tale that has enchanted investors for a decade: neither too hot nor too cold, and always just right for profits.
“ The question is whether the new era that is now dawning will be dominated for the first time in a generation by sustained rapid price growth; or whether, for the first time in history, we will overcome an inflationary crisis painlessly with negative real interest rates and without the collateral damage of a major recession.”
Investor optimism is evident in the trillions of dollars recently wagered on three closely related market bets. Financial markets are now predict that US interest rates are FF00,
will peak below 3.5% in January 2023 and then decline from April next year to around 2.5% in early 2024. Bond Markets TMUBMUSD10Y,
are priced for US inflation to collapse from 9.1% today to just 2.8% in December 2023. And the stock markets SPX,
expect the economic slowdown causing this unprecedented disinflation to be mild enough to weigh on US corporate earnings increase by 9% by 2023 from this year’s record values.
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. This is what these models assume expectations low inflation are key to maintaining price stability. Central bankers therefore regard “well-anchored” inflation expectations as proof that their policy works.
When central bankers and markets follow one another, both are likely to be misled. However, this only partially explains the financial markets’ willingness to bet against it warnings by eminent commentators such as Larry Summers, Mohamed El-Erian, Jim O’Neill and Nouriel Roubini on a return to 1970s-style stagflation.
Buy to the sound of guns
I have just spent three months traveling the world discussing with hundreds of professional investors why I too have switched to a clearly bearish outlook after a decade of panglossic optimism about the financial markets outlook. These discussions have convinced me that today’s investor confidence is based on four fallacies, or at least cognitive biases.
The first cognitive bias is to downplay and defy geopolitics – a view summarized by Nathan Rothschild legendary directive in the Napoleonic Wars to “buy from the cannon fire”. Professional investors pride themselves on trading against panicked retail investors selling their assets over wars.
This contrarian approach has often proved correct, albeit with one glaring exception. The October 1973 war between Israel and a coalition of Arab states permanently led by Egypt and Syria transformed the world economy in a way that ruined a generation of cocky investors. They downplayed events that were eerily reminiscent of today: an energy shock, a surge in inflation after a long period of monetary and fiscal expansion, and the confusion among policymakers faced simultaneously with high inflation and rising unemployment.
to squeeze Russia, one of the world’s largest energy producers CL00,
and many other commodities from global markets has created a supply shock at least as severe as that of 1973-74 Arab oil embargo and lasts for years. Restoring price stability therefore now requires a long-term demand restraint strong enough to accommodate the reduction in commodity supply. That means a hike in US interest rates to 5%, 6% or 7% instead of the 3.4% peak that investors and central banks are now expecting. However, investors’ Pavlovian reflex is to downplay these geopolitical upheavals and instead focus on small adjustments in US monetary policy.
The 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 market-moving economic indicators such as inflation, unemployment or interest rates are more important than theirs levels.
Many investors therefore believe that monetary conditions have become very tight as central banks hiked rates in 0.75 percentage point increments instead of the usual 0.25 percentage point, although rates are still much lower than in any previous tightening cycle.
Similarly, investors seem unfazed by a surge in inflation above 9%, as they expect it to fall to “only” 7% by December. But firms and workers in the real economy will still see prices rise at their fastest pace in decades, which is bound to drive firms’ pricing strategies and wage negotiations for 2023.
Don’t fight the Fed
Such a conclusion seems obvious — except for financial traders, who are subject to a third cognitive bias: “Don’t fight the Fed.” This popular market wisdom says that investors should always assume that once the Federal Reserve does, it will prevail is serious about achieving a goal, e.g. B. an inflation target.
This makes sense if the Fed is genuinely willing to do whatever it takes to meet its goals, such as clearly targeting low inflation, regardless of the impact on unemployment, stock markets, and debt-servicing costs. But today’s Fed is so focused on “well-anchored” inflation expectations that it’s quite relaxed about “hindsight” data that continues to show prices are rising much faster than most companies and workers have ever seen.
Nothing new under the sun
This leads to a final bias: most people find it difficult to imagine events that have never happened in their lives. For many investors and policymakers, persistently high inflation falls into this category. Market wisdom expresses this bias with the saying that “there are no new ages”.
But there are new epochs, 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 that guarantee that the coming period will be very different from the past 40 years.
The question is whether the new era that is now dawning will be dominated for the first time in a generation by sustained rapid price growth; or whether, for the first time in history, we will overcome an inflationary crisis painlessly with negative real interest rates and without the collateral damage of a major recession. Markets and central banks are confidently expecting a new, carefree era. If they’re 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 after the crisis” (Public Affairs, 2011).
More about the market and the economy
Nuriel Roubini: Stocks could fall 50%. Things get way worse before they get better.
Joseph Stiglitz: How an arrogant and pathological America could lose the new Cold War
Mohamed El Erian: The people in the global penthouse should worry about the “little fires everywhere” in the basement
https://www.marketwatch.com/story/four-fairy-tales-that-stock-market-investors-and-economic-policy-makers-are-telling-themselves-11659622840?rss=1&siteid=rss Comment: Four fairy tales that stock market investors and economic politicians tell each other