At first, surging inflation was “transitory”. Then it went on too long to be transitory. So the word “transitory” was dropped (officially, by the Federal Reserve) around the end of last year.
However, markets still haven’t given up hope.
You can understand why. Commodity prices have crashed this year. Oil prices haven’t crashed, but they have stalled.
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And most of the market (almost certainly correctly, as I’ll explain below) expects a recession in the imminent future.
So we moved into the phase where every month was surely going to deliver the evidence that the worst inflation reading was behind us, and at that point, team “transitory” would have been proven correct, if a little early.
I mean, maybe it’ll happen one day. But yesterday was not that day.
Inflation just isn’t calming down
I realise the majority of our readers are UK based. But one of the features of a globalised financial system is that what’s going on with the other big players really matters for investors everywhere. Not least when the biggest player – the US – also controls the world’s reserve currency.
We used to run on a gold standard. Now we run on a dollar standard. So just as the tides of gold flowing around the world (or at least, moving from one end of a vault to another) would play havoc with markets and economic policy everywhere, so the motions of the dollar now do the same.
Put more simply, what happens in the US really matters for all our portfolios.
Yesterday, US inflation hit another fresh 40-year high. It also beat expectations – yet again. In terms of crumbs of comfort – well, there weren’t any. Headline prices rose at an annual rate of 9.1% in June, compared to 8.6% in May.
John Authers writing for Bloomberg rather summed it up when he pointed out that US inflation is now higher than Mexico’s. He also notes that “sticky” inflation (as measured by the Atlanta Federal Reserve bank) is now back to 1970s levels.
None of this is to say that inflation won’t peak at some point – of course it will. But those who hope that just because copper, say, has plunged into a bear market, that we’re on the verge of actual deflation, are going to be disappointed.
So what’s the effect of all this on markets?
Well, this is where it gets a little complicated. And to give you my view before I explain in more detail, I think the market reaction shows that investors are still focusing on the wrong problems.
Markets are expecting – even hoping for? – a recession
Markets are already predicting a recession. This is understandable and the odds suggest that they are right to do so. Why do I say that?
Well, people will tell you that no economic timing indicator is perfect. That’s absolutely true, nothing is.
But an inverted yield curve is the closest thing we’ve got to a perfect indicator and the reality is that it has a superb track record of predicting recession. (You can read what an inverted yield curve is here).
Given how solid its post-war record has been – predicting every recession correctly with only one false positive in that entire time – it seems foolhardy to bet against it. I’ve seen this several times, and every time you get a swathe of articles and academic papers explaining why the yield curve might be wrong this time.
This inversion has been no different. But if you play the odds (and what else can you do as a sensible investor?), then betting against a US recession at this point is the wrong move.
Of course, none of this is much help in terms of your personal investing. You still can’t time the market using the inverted yield curve.
However, it does show why the market reaction yesterday was weirdly muted. Markets are already assuming that we face a recession. That recession will be caused, they believe, by the Federal Reserve raising interest rates until the pips squeak, basically.
Yesterday’s higher-than-expected inflation reading merely confirmed this existing view. That’s why the threat of a full percentage point interest-rate rise didn’t absolutely crater stocks.
Where it gets trickier is this: the longer-run belief is that the Fed will manage to squeeze inflation out of the system. And at that point, the central bank can cut rates, and everything will be – well, not exactly hunky dory again, but back to where it was.
You need only look at the performance of the more interest-rate sensitive “jam tomorrow” stocks in the last month or so. The ARK Innovation ETF, which is my go-to indicator for this stuff, is up about 20% in the past month (some would call that a bull market!).
There’s still a lot of volatility in there but you can see that investors are now looking forward to a time again when interest rates are falling, and their knee-jerk reaction is to buy the same stuff that they bought the last time.
This, by the way, seems a bit odd, given that growth stocks surely are not a good bet in a recession, but never underestimate the staying power of a trend.
Anyway – it seems to me that markets are setting themselves up for disappointment. It’s easy for the Fed to be relentless right now because employment remains high and the political pain is being caused by the soaring cost of living.
But how will it react if and when job losses begin and the cost of living is still stratospheric? And what will that all mean politically? And what will happen when recession fear starts to pass and as a result, commodity prices rebound sharply (because the current falls are arguably being driven partly by financial flows retreating and other temporary factors rather than because a flood of new supply has hit the markets)? ��
We’ll see. I’m not convinced inflation will be beaten that easily. And I suspect that, as a result, markets will be choppy and hard to navigate for a lot longer. What does it mean for you? Stick to your plan, have cash to take advantage of opportunities, and just be prepared for more turbulence. No heroics.
John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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