Grumpy investors see bright side in growth risks

I am allowed to say this because I come from farming stock myself: farmers complain constantly, about everything. Too wet, too dry, too hot, too cold, etc etc. Investors are not so different.

The opening months of this year brought an inflation panic. Bonds dropped hard because they are allergic to inflation, which eats in to their (rather skimpy) fixed payouts. Stocks dropped because fund managers decided that the US Federal Reserve would dish out half-point rate rises like sweets at every meeting to try and pull inflation down. The “everything rally” unravelled and left many fund managers with nowhere to hide. The horror!

Now, the inflation panic appears to be abating. The new worry in town is of the potential for a serious slowdown in growth or even, in the worst-case scenario, a full-blown global recession. Kindly adjust your grand market narratives accordingly.

The thrust here is that monetary policy is a pretty blunt tool. Inflation has soared well above key central banks’ mandated targets, cornering policymakers in to aggressive tightening, with rate rises and with cuts to the huge balance sheets they have racked up with asset purchases since the 2008 crisis, topped up of course in 2020.

The problem is that central banks are limited in their ability to tame the type of inflation we are suffering. They cannot end China’s Covid lockdowns, produce microchips or manufacture peace in Ukraine. Unless they can fix that third issue in particular, they are likely unable to pull down energy prices and, by extension, temper workers’ (perfectly reasonable) requests for higher pay.

“They want to get inflation down but they know they can’t do anything about the energy part,” says Gareth Colesmith, head of macro research at Insight Investment. “If they are serious about bringing it under control, then they need to do something about the demand for labour, since they can’t do anything about the supply. So you induce a slowdown, and that does bring a risk of tipping into a recession.”

A policy error is one way to induce a recession, but not the only one. In any case, economic data releases in the US are now frequently undershooting market expectations. Citi’s US economic surprise index has plunged to its lowest level since September.

A “proper” recession — not another quarter of tame contraction driven by technicalities, but a deep and enduring decline — is far from a certainty. It is clearly not what businesses and households want to see after an already testing couple of years, nor is it what policymakers want to engineer.

But you can tell the idea is taking root with investors from several angles. The key one is that government bond prices have levelled off after a steep decline, suggesting that not only are inflation expectations coming off the boil, but that investors are bracing for slower growth and even for a slower pace of central bank tightening. The benchmark US 10-year Treasury note was yielding 2.91 per cent on Thursday — high by the standards of the past few years but well down from the peak above 3 per cent seen in early May. Similarly, the dollar has pulled back.

But of course, Wall St and Main St are very different beasts. A cooling dollar and lower bond yields are, all things being equal, good for equities. Already, the bounce is pronounced — the S&P 500 benchmark index of US blue-chip stocks has climbed by as much as 9 per cent since its low point on May 20. The MSCI World index is up by a more modest but still impressive 6 per cent. Corporate bonds have also sprung back.

The big question, though, is whether the simmering growth scare will be enough to throw the Fed’s tightening off track. Barclays, for one, doubts it. “The Fed is unlikely to blink until inflation expectations are re-anchored for good,” the bank’s analysts wrote in a note to clients. “We think the Fed will want to see evidence of much lower inflation, and/or much tighter financial conditions” before tearing up its plans, it said. “Until then, expect choppy markets to continue.” 

It added that while hedge funds were big sellers of equities in May, mutual funds, which have pumped some $1.3tn in to the asset class since 2020, have only just started to withdraw. If recession fears stick, “there could be another $350bn of selling equities down the road” from these funds, the Barclays analysts said.

David Riley, chief investment strategist at BlueBay Asset Management, also thinks the latest recovery in stocks and other risky assets is most likely to be a blip. “Don’t fight the Fed,” he says. Policymakers actively want to see higher borrowing costs that help to cool some elements of inflation without the central bank having to rush rate rises, he adds.

Instead, if markets do keep sailing higher, it might be wise to anticipate rather more hawkish commentary from rate setters. “I’m sceptical how sustained this mini rally can be,” he says.

For now, we are back in the zone where bad news on economic growth is good news for riskier markets as it means less upward pressure on rates. If you can stomach the volatility, and secretly love to complain, this is a perfect combination.

katie.martin@ft.com