Inflation back at the top of the fear list for worrywart investors

And relax. After months of performative wrangling, the showboats of US politics have finally agreed to give the country more leeway in borrowing, a move that extinguishes the risk of a potentially cataclysmic default on its government bonds.

Averting a disaster in the world’s core so-called risk-free asset, this is victory for common sense. 

If you are heavily invested in chipmaker Nvidia and other big-name US tech stocks, you are living your best life regardless of this whole pantomime. For everyone else, the deal on the debt ceiling is a rare jolt of good news in a worrywart year, as HSBC summed up nicely this week.

“Recapping the first five months of 2023 reads more like a song list of doom-mongers rather than anything else,” Max Kettner, chief multi-asset strategist at the bank wrote this week. Aside from the US debt ceiling tussle, fund managers have had to contend with a string of US bank failures, alarm over a credit crunch and constant warnings about a horror show in corporate earnings. 

Conspicuously, risky markets have kept motoring higher anyway. Sure, US stocks in particular are dominated by a tiny clutch of high-flying names, without which they would be flat this year. Opinion is divided on whether that is, in itself, a cause for alarm. Either way, the S&P 500 has gained about 10 per cent so far in 2023 despite the laundry list of risks and shouty warnings of imminent disaster. Even Kettner, who has been an optimist on risky asset prices all year, is growing nervous this has gone too far.

The question now is whether clearing a US default off the agenda clears the way for some punchy new rallies in US and indeed global stocks. The sense is that it is a necessary precondition, but probably not enough on its own. 

“The rally needs more,” wrote Mark Haefele, UBS Global Wealth Management’s chief investment officer. “While the prospect of a [debt ceiling] resolution is positive for risk sentiment and may support stocks in the near term, we still think the risk-reward balance for broad US equities remains unfavourable amid other macro challenges.”

At the risk of sounding like a broken record, top of that list of macro challenges is, you guessed it, inflation – the corrosive force that chewed up and spat out fund managers last year by hurting both stocks and bonds. Few are keen on a re-run.

Evidence that the dreaded i-word is simply not backing down is everywhere. The UK is something of an outlier, of course. But core inflation is proving annoyingly sticky, and food prices are up almost 20 per cent in the past year. Bracing stuff. Meanwhile, the US Federal Reserve’s favoured inflation measure – the personal consumption expenditure data – is still rattling along. Core PCE was shown earlier this month to be running at 4.7 per cent a year, well above the Fed’s target. The rapid return to low and, crucially, stable inflation, is stubbornly refusing to materialise.

“People talk about the peak in inflation, but they don’t see the next waves coming,” says Frédéric Leroux, head of the cross-asset team at Carmignac in Paris. “We have had the first peak, but there will be a series of them in the coming years.”

Too often, he says, investors and analysts infer that the rapid acceleration in price increases after the Covid-era lockdowns had one big fixable source – the shutdown and reopening of global supply chains – and another less fixable one: the war in Ukraine.

Instead, broader interlinked forces are at play, from reshoring to the reset in global geopolitics to the green energy transition, all of which point to higher structural inflation for decades to come. “The market is of the view that inflation is transitory,” Leroux says. “It’s not.”

For him this bolsters the case for active rather than passive fund management, for tilting away from growth stocks, particularly in the US, and instead towards unloved pockets of value. He is drawn towards Japan, Europe and Asia. “We have this big wave [of investor interest] from west to east,” he says.

Michael Saunders, formerly a member of the Bank of England’s monetary policy committee and now a senior policy adviser at Oxford Economics, suggests this may be a little pessimistic.

“Inflation will not go away as quickly as it came,” he says. “The ‘immaculate disinflation’ where it shoots up and then shoots down again looks less plausible now. But I believe that central banks will eventually get there. So we won’t have structurally higher inflation, but we will have structurally higher interest rates to make sure it’s not persistent.”

This message is cutting through. Expectations for a cut in US interest rates to soften the blow of stresses in the banking system are now melting away. Futures markets have swung from anticipating that the Fed’s next move will deliver welcome relief with a cut, to baking in a roughly one-in-three chance of a rise.

Strip out those high-flying tech stocks and suddenly it looks like those doom-mongers are still cracking out their greatest hits. Inflation remains top of the pops.

katie.martin@ft.com