Tough road for markets as inflation battle eases

It tenses the spring for a wealth boom in the second half of the year as the stars align on investor nirvana: a monetary thaw; Light at the end of the tunnel in Ukraine; full economic reopening in China after the Omicron massacre; and relief that globalization lives on.


A chastised Xi Jinping will tone down his wolf warrior macro-Leninism, because China cannot do without Western investment and chip technology. Emerging markets are the place to be after 15 years of going nowhere. They are extremely cheap.

The US Federal Reserve’s broad dollar index rolled over after hitting an all-time high in October. The US dollar is now in a secular downtrend that will accelerate once the Fed turns around and starts cutting rates.

This will ease the painful bottleneck in the $14 trillion offshore dollar debt market, the key lubricant of global trade and investment.

But first, central banks must correct their next mistake. Having unleashed an inflationary storm by ignoring the warning signs of an explosion in the broad M3/M4 money supply – which typically hits with a one to two year lag – they are now making the opposite mistake. They deepen too much into an engulfing recession after monetary growth has collapsed.

The Fed has tied its credibility - and the fate of the US economy - to jobs and core inflation.

The Fed has tied its credibility – and the fate of the US economy – to jobs and core inflation.Credit:Bloomberg

The result is already visible in America. According to the Institute of International Monetary Research, M3 shrank by a nominal 4.9 percent annually in the three months to November. It has dropped to almost zero year after year, something that never came close to happening in the 1970s.

The Fed isn’t looking at that flashing red signal. It has tied its credibility – and the fate of the US economy – to two sets of lagging indicators: jobs and core inflation. The Fed’s Jay Powell is not an economist. It’s good. He will realize that a mistake is being made – late, but not disastrously late – instead of bringing down the ship with an academic idée fixe.

The European Central Bank will linger longer because the Eurotower is not about monetary policy, but about a power struggle between the creditors in the north and the debtors in the south over the economic machinery of the euro zone. The Bundesbank is back in charge, and that will be painful for an economic bloc already facing factory closures, with the risk of permanent deindustrialization the longer Vladimir Putin’s war drags on.

As in 2008 and 2011, the ECB will continue to drag itself into the energy storm until the ground crumbles beneath its feet. Giorgia Meloni’s honeymoon for Italy cannot last. Once risk spread in Italian 10-year debt exceeds 250 basis points, slow contagion will spread to Club Med, the Baltics and overwhelmed ERM peggers like Romania. Markets will turn their attention to the ECB’s suspected anti-spread tool and conclude that it can only be used in extreme cases.

President Emmanuel Macron tends to leave the door to Russia open.

President Emmanuel Macron tends to leave the door to Russia open.Credit:AP

The Bundesbank will find reasons not to use it and will instead ask Meloni to ratify the EU bailout fund, which it refuses because the instrument means austerity if it is ever used by colonial commissioners from Brussels. This will be the political battle of 2023.

France has delayed all of its problems by subsidizing everything from diesel to condoms and suppressing any price signal it doesn’t like.

But this year Emmanuel Macron has to admit that “whatever it takes” is no longer affordable. His valiant attempt to raise the retirement age above 62, the sine qua non for France’s financial viability, will spark a late winter of discontent – or in the vernacular of Gallic, a Yellow Vest II.

Putin could spoil the recovery in the second half by adding an oil crisis to the gas crisis.

Thank goodness for the Bank of England and monetary sovereignty. Threadneedle Street pays attention to the money supply – up to a point – and will stop tightening sooner than others. This will mitigate some of the damage. Sterling will therefore weaken. The usual suspects will use this as an indictment on Brexit and the usual fools will believe them.

The UK recession will not be the worst in the G7, as the financial press keeps telling us. The now well-known Brit-bashing from the Paris OECD will again prove to be exaggerated, also because of open-door immigration.

The final balance up to the end of 2023 is that the UK economy will have grown at around the same rate as the eurozone Big Four since the pandemic began and since the referendum.

Putin could spoil the recovery in the second half by adding an oil crisis to the gas crisis in hopes of fomenting a political insurgency against Europe’s shaky governments before the war’s attrition finishes it off.

He surely wants to believe that this is his plan. My guess is that he won’t dare. It hurts most people in the world. He cannot afford to irritate China and India any further or lose sympathy for the Global South any further.

My other guess—low conviction, hedge funds say—is that the outlines of a settlement in Ukraine will emerge after the spring thaw in Rasputitsa, messy as it may be. It will end in a division along the lines of the 38th parallel in Korea, or rather the 17th parallel in Vietnam, which before the next war proved to be only a stop line. It won’t be a lasting peace, but it will be rocket fuel for asset markets.

Annus mirabilis? Not quite, but not a disaster either. Happy New Year.

The Daily Telegraph Tough road for markets as inflation battle eases

Brian Lowry

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