Given the dismal performance of stock and bond portfolios over the past year, you may not have realized that the financial markets are awash in over-optimism. However, there is no other way to describe today’s investors, who since the fall have been increasingly betting that inflation, the biggest problem in the global economy, will disappear without major shocks. The result, many believe, will be lower interest rates towards the end of 2023, which will help the world’s major economies – and in particular the United States – avoid a recession. Investors price stocks for a Goldilocks economy in which corporate profits rise healthily while the cost of capital declines.

In anticipation of this turn of events, the index S&P500 US stocks are up nearly 8% year-to-date. Companies are valued at around 18 times their future earnings, which is low by post-pandemic standards but at the high end of the range that prevailed between 2002 and 2019. And by 2024, those earnings are expected to rise nearly by 10%.

It’s not just US markets that are up. European equities rose further, thanks in part to a warm winter that dampened energy prices. Money has flowed into emerging economies, which are enjoying the double blessing of China’s abandonment of its zero interest rate policy and a cheaper dollar, a result of expectations of a more robust US monetary policy. soft.

The S&P500 index of US stocks is up almost 8% since the start of the year. Companies are valued at around 18 times their future earnings, a low level by post-pandemic standards, but at the upper end of the range that prevailed between 2002 and 2019.

It’s a pink picture. Unfortunately, as we explained this week, that’s probably wrong. The global battle against inflation is far from over. And that means the markets could take a bad correction.

To get an idea of ​​what has raised investors’ hopes, let’s take a look at the latest US consumer price figures, released on February 14. In the three months leading up to January, inflation was weaker than at any time since the start of 2021. Many of the factors that caused inflation to take off have dissipated. Global supply chains are no longer overwhelmed by increased demand for goods, nor disrupted by the pandemic. Demand for patio furniture and game consoles has cooled, real estate prices are plummeting and there is a glut of microchips. The price of oil is lower today than it was before Russia invaded Ukraine a year ago. The panorama of the lower inflation it is repeated throughout the world: the general rate is falling in 25 of the 36 richest countries of the OECD.

However, fluctuations in headline inflation often mask the underlying trend. Looking at the details, it is easy to see that the inflation problem is not solved. The costs “underlying from the United States, which excludes volatile foods and energy, grew at an annualized rate of 4.6% over the past three months, and began to accelerate smoothly. The main source of inflation is now the sector services, more exposed to labor costs. In the United States, Great Britain, Canada and New Zealand, the growth of wages it remains well above what the 2% inflation targets of their respective central banks allow; wage growth is weaker in the euro zone, but is increasing in large economies such as Spain.

European equities rose further, thanks in part to a warm winter that dampened energy prices. Money has flowed into emerging economies, which are enjoying the double blessing of China’s abandonment of its zero interest rate policy and a cheaper dollar, a result of expectations of a more robust US monetary policy. soft.

This should come as no surprise, given the strength of labor markets. Six of the major rich countries of the G7 have an unemployment rate at or near the lowest this century. The US is at its lowest since 1969. It’s hard to see how core inflation can dissipate while labor markets remain so tight. Many economies remain on track for inflation that does not fall below around 3-5%. It would be less terrifying than the experience of the past two years. But that would be a big deal for central bankers, who are judged by their goals. It would also put a dent in the optimistic view of investors.

Whatever happens, it seems likely that they will happen turbulence in the markets. Over the past few weeks, bond investors have started to gravitate towards the prediction that central banks will not cut interest rates, but rather keep them high. It is conceivable – only – that rates will remain high without seriously hurting the economy, while inflation continues to fall. In this case, the markets would benefit from strong economic growth. However, consistently high rates would inflict losses on bond investors, and maintaining high yields without risk would make it harder to justify trading stocks at a high earnings multiple.

However, high rates are much more likely to harm the economy. In the modern era, central banks have been bad at “soft landings,” completing a cycle of rising interest rates without triggering a recession. History is replete with examples of investors mistakenly anticipating strong growth towards the end of a period of monetary tightening, only to end up in a recession. This has happened even under less inflationary conditions than the current ones. If the United States were the only economy to enter a recession, much of the rest of the world would be dragged lower, especially if the flight to safety strengthened the dollar.

Over the past few weeks, bond investors have started to gravitate towards the prediction that central banks will not cut interest rates, but rather keep them high. It is conceivable that rates will remain high without seriously weighing on the economy, while inflation continues to decline.

It is also possible that central banks, faced with a stubborn inflation problem, do not have the courage to tolerate a recession. Instead, they could let inflation slightly exceed their targets. In the short term, it would be a sugar rush for the economy. It could also be beneficial in the long run: over time, interest rates would rise due to higher inflation, moving them away from zero and giving central banks more monetary ammunition in the next downturn. For this reason, many economists believe that the ideal inflation target is above 2%.

However, managing such regime change without wreaking havoc would be a daunting task for central banks. Last year, central banks emphasized their commitment to current targets, often set by lawmakers. Abandoning one regime and establishing another would be a unique political challenge. In the 1970s, the lack of clarity about monetary policy objectives caused wild swings in the economy, which harmed both the public and investors.

Back on earth

So far, central bankers in rich countries have shown no signs of changing course. But even if inflation drops or they give up on fighting it, policymakers are unlikely to execute a flawless turnaround. Whether it’s rates that remain high, a recession that hits, or politics that enters a delicate transition period, investors have prepared for disappointment.

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