Higher interest rates remain the biggest risk for Financial Markets.
For investors and more broadly financial markets, an unfamiliar foe of rising inflation has swept across the world over the last eighteen months, and central banks are now walking the fine line of trying to cool inflation while preventing an economic slowdown. However, policy makers are clearly more concerned with the former, that inflation will not only become imbedded in consumer and business expectations, but will also unhinge delicate political and geopolitical balances around the world.
Whenever governments panic and significantly increase fiscal spending, inflation will tend to overwhelm the usual disinflationary pressures in an economy. Over the last two years, we have encountered both aggressive government fiscal intervention (spending on housing, climate change, transport, and job schemes) as well as multiple black swan events; from COVID and its variants, to Russia’s ongoing occupation of Ukraine. The global policy maker response to the waves of COVID-19 was to support demand at any cost. The largest ramification of this demand support and surge was the suppliers lack of capacity to deal with this overwhelming force. The combination of haphazard lockdowns and inability of suppliers to ramp-up production to satisfy the sudden boost in goods demand has driven the shortages and bottlenecks along transport chains. As it stands, Goods demand globally is now at least 10% above long-term trajectory (much more so in the US), while services demand is now at least 5%-15% below trajectory.
The COVID-inspired disequilibrium between goods demand and supply was then further aggravated by Russia’s invasion of Ukraine, and a subsequent squeeze in the commodity space (from oil and gas to nickel and rare earths). Renewed lockdowns in China have also added to pressures in recent weeks.
From here, I think central bank policy error (and the accumulation of errors) is the single most important risk facing investors. Policy makers have flagged and are embarking on significant tightening cycles to reduce demand and moderate inflation. However, societal indebtedness aside, we think many of the drivers causing the headache are temporary in nature, and as a result think global interest rate trajectories will need to be revised to again support or stabilize demand.
Three key drivers will likely shift demand over the coming months:
(i) An accelerated withdrawal of government spending. Global economies are on track to reduce fiscal deficits from ~11%-12% of GDP in 2021 to ~6%-7% in 2022, before further reducing in 2023. This represents a withdrawal of roughly US$3tr of fiscal stimulus, and the fastest and the deepest fiscal contraction since the end of World War II.
(ii) In the economies now undertaking interest rate hikes (the US, Canada, Australia, New Zealand, Korea, Singapore, and the UK), the current pathways imply ~US$2-3tr of monetary accommodation will be taken out of demand over the next 18 months.
(c) Unlike previous tightening periods (e.g., 2015-18), this time around the contraction of both fiscal and monetary support is truly global and effectively coordinated, driven by the single most important economy (i.e., US).
Are we already seeing evidence of a slow down? The answer is yes – policy decisions from here will likely drive to what extent and just how protracted it will be.