Looking Beyond Ukraine 

It’s easy to blame Russia’s invasion of Ukraine for the current stock market weakness. The recent slump in global equities along with the surge in crude oil and precious metals coincide with Putin’s unforgivable attack on Ukraine. But without wanting to play down the seriousness of this terrible situation, and the appalling place that Ukraine’s citizens find themselves in, that’s only part of the story for financial markets. 

The biggest concern for investors is the change in rhetoric from the US Federal Reserve as the central bank pivots from wildly stimulative to hawkish in an attempt to curb inflation. With the headline annualised Consumer Price Index (CPI) at +7.5%, its highest rate in 40- years, inflation is already too high for comfort. And given that the Producer Prices Index (that is, what companies pay for raw materials and other costs) is currently close to +10%, inflation could rise further. 

Inflation isn’t transitory

Putting aside questions over the Federal Reserve having the wherewithal to control inflation, at least they now accept it’s a problem. Central banks spent much of last year playing down inflationary fears. But if there’s one thing we’ve learnt over the last six months or so, it’s that inflation isn’t transitory.  In truth, the world’s major central banks have been desperately trying to create inflation for years now. All have inflation targets which tend to come in around the 2% level. But this 2% target was first established back in the 1990s when high inflation was a serious problem. Back then, the aim was to drive inflation down to 2%. But ever since the Great Financial Crisis of 2008/9, when debt levels soared, central banks have been desperate to push inflation up to 2%. 

Well, they’ve certainly achieved their objective, but why would they want to do that? Because creating inflation is the easiest way of getting rid of debt. It’s certainly easier to inflate it away, rather than paying it back to the lender or defaulting for that matter. 
But inflation is not only difficult to control, as we’re now seeing, but it’s also damaging and demoralising. Recently Loretta Mester, President and CEO of the Federal Reserve Bank of Cleveland, said: “High inflation imposes a real burden on households and businesses, especially those that do not have the wherewithal to pay more for essential goods and services”. She went on to warn that this feeds through to expectations of ever rising inflation, and then constant wage demands which only add to pricing pressures. 

Inflation hurts

As she noted, it is those on fixed incomes who suffer most. But savers also lose out. Real interest rates, that is interest rates minus inflation, are solidly negative. Just consider the situation in the US: with the CPI at +7.5% annualised, and interest rates currently little more than zero, even if you were able to earn 0.5% on your savings annually, inflation would see your capital’s spending power decline by 7%. Better to spend it on hard assets or take a risk buying equities and hoping for capital growth. 
But the latter is proving problematic as the world’s major stock indices have come under sustained selling pressure since the beginning of 2022. The S&P 500 is currently down over 10% since hitting a record high at the beginning of the year. The tech heavy NAASDAQ 100 has lost 16% over the same period.

Tighter monetary policy

The main reason for this sell-off is the spectre of tighter monetary policy. At the end of last year the US Federal Reserve made it abundantly clear that it is concentrating its firepower on reducing inflation. Tighter monetary policy means winding down its bond purchase programme, raising interest rates and reducing its balance sheet which currently is around $9 trillion. 

James Bullard, president of the Federal Reserve Bank of St. Louis, has said that the central bank should raise its fed funds rate by 1%, or 100 basis points, between now and the beginning of July, or risk damaging its reputation. But this carries dangers. Asset prices, such as bonds, equities and property, have soared on the back of loose monetary policy. The danger is that when you reverse the process, everything that went up will suddenly go down. As investors will have raised credit on the back of inflated asset prices, and leveraged up, it won’t take much of a decline to trigger a wave of selling, with the most liquid assets, such as bonds and equities, the first to be sold.

Another taper tantrum?

The prospect of tighter monetary policy has led to renewed fears of a taper tantrum. This has happened a couple of times since the Great Financial Crisis of 2008/9. Back in 2013, then Federal Reserve chair Ben Bernanke surprised the markets by announcing he planned to reduce the central bank’s bond purchase programme. All hell broke loose across global financial markets. In 2018 the current Federal Reserve Chair, Jerome Powell, then set about raising rates and reducing the balance sheet (which was then around half its current size). But once again, markets reacted violently with the S&P 500 falling by 20% in the last quarter of that year. 

We’re seeing a similar reaction right now. If there’s one thing investors really dislike, it’s the uncertainty that arises when the Fed raises rates while simultaneously reducing its balance sheet. The big question now is whether the US central bank has the guts to take the aggressive measures necessary to calm inflation. It’s already possible that the uncertainties caused by the hostilities across Ukraine have given them an excuse to tone down their hawkishness. But as the situation deteriorates, energy prices will continue to rise, adding to inflationary pressures. Given these concerns, do they dare retreat? It’s an unpleasant position to be in, but it’s one that the Fed brought on itself.