Inflation? A Covid relapse? Markets are trying to work out what’s coming next

We’ve come a long way over the past 18 months.

We’ve seen a global pandemic erupt, the economy locked down, markets crash as a result, and governments and central banks pile in to react.

Weirdly enough, those extremes were the points at which investment decisions were easiest. (Terrifying, maybe – but easy.)

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Now markets have rebounded strongly. But no one knows if inflation is transitory or here to stay. And the re-opening has been worryingly stop-start in nature.

So what should investors do now?

Markets predict the future (or at least they try)

No one in markets has a crystal ball. And yet markets themselves are arguably the closest thing we’ve got to functional clairvoyance.

It’s the whole point of markets. We trust and incentivise the wisdom of crowds to bring their best opinions to market and thus allocate resources in a way that profits everyone – the best ideas get funded, the worst don’t, and so labour and capital get employed in the best possible manner.

(This is the ideal, obviously, but markets appear to have served better as a mechanism for this than anything else that have been tried on a big scale so far.)

Anyway, that’s one reason why equity markets started pricing in a recovery almost from the minute that we all woke up to the fact that this was really serious.

There is also, of course, the fact that as soon as we all realised that this was really serious, the developed world’s central banks, led by the Federal Reserve in the US, started to take unprecedented (there’s that word again) action to prevent a complete meltdown. The Fed went as far as buying junk bonds – effectively abolishing bankruptcy for a wider layer of companies than ever before.

Meanwhile, governments relied on the largesse of central banks to prop up public spending packages on a scale that hadn’t been seen in peacetime, ever.

So there was basically no reason not to invest. And, what with investors having been trained over the last decade to buy on central bank action, it’s no wonder we saw such a rebound.

However, just as markets priced in the recovery before it actually happened, you have to accept that they’ll try to price in whatever comes next before it actually happens too.

We’re at the stage now, and have been for a while, where investors believe the recovery is real. But we’ve seen the big rebound on the back of that. So what’s next?

The two big questions the market is trying to answer

As far as I can see, the market is now waiting on the answers to a couple of key questions.

One is: how inflationary is all this really? Is this all transitory? It’s pretty clear on this front that investors are willing to give central banks the benefit of the doubt here. But this belief that inflation is transitory has also been given credence by the Fed nodding towards being a bit more worried about inflation than it had suggested.

It’s all a bit “zen” – but if the Fed has dialled back on the “we don’t care about inflation” rhetoric then that in turn implies that inflation really is more likely to be transitory, because if it’s not, the Fed will be more responsive than its previous attitude had implied.

So I’d say the market currently doesn’t expect inflation to get out of hand. You can see that in the fact that the Nasdaq is doing so well (doesn’t like rising inflation), and bond yields have dropped back, while some of the energy has gone out of commodities, and gold in particular.

Two – and this is arguably the more important question: are we ever getting back to “normal” and if we do, what will it look like? The Indian or Delta variant has caused a resurgence of concern.

The situation in India is now improving, and it so far looks as though vaccines are pretty effective at stopping the worst outcomes, but the number of school kids being sent home in the UK shows that Covid is still a serious issue and a disruptive one (even if that’s down to over-testing and therefore lots of false positives, the point stands).

The second question is at least as complicated as the first to answer. You have two factors: there’s the actual fear of a genuine resurgence in a nasty variant that puts back a lot of the progress we’ve made, and then there’s the question of whether we can roll back the tendency to retreat to lockdown at the drop of a hat.

The thing that concerns me about emergency measures is that they have a habit of outlasting the emergency. They then become a standard measure, rather than an emergency one.

We’ve seen it with central banks; now we’re seeing it with governments. We know what the market crash playbook is – print money. We now know what the pandemic playbook is – lockdown, print money. What’s the threshold now? Can we expect this sort of thing with every bad flu season? What does that mean for the economy?

These questions are really hard to answer. From a financial markets point of view, investors are frankly probably not too concerned to have a question mark over future growth because it means they can go back to “business as usual” – an OK-ish economy accompanied by low interest rates, semi-permanent money printing, and a “buy the dip because there’s nothing else to do” mentality.

That’s the “Goldilocks” scenario. That does still seem to be what markets are tentatively pricing in. Inflation being stronger than expected or a nasty global resurgence in Covid would demolish that scenario in very different ways.

All I can say is: watch the data. I’m in the “inflation will be stronger than expected” camp – partly because I think central banks and governments will push it to be if it shows signs of faltering. But we just need to wait and see.

On that front, one thing to watch is the US jobs data this Friday. Payrolls data seems to have regained its former importance in the market’s eyes. Strong results will imply a stronger recovery, but also higher interest rates; weak results will imply the opposite. Whatever the market believes after that data release will quite possibly shape the tone for the rest of the month.

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