The worst is probably behind us, but there is a real risk of resurgent inflation.
This year has begun with most of the developed world in or approaching recession. This state of affairs has been induced by a reduction in real incomes, courtesy of higher prices and by tighter monetary policy, triggered by the increase in inflation.
Fortunately, the shocks to the price level are mostly in the past, and slower growth or recession should be enough to bring inflation back to target – that is Fathom’s central case. In most countries the recession will be short-lived, a ‘pause that refreshes’ – though the UK might be an exception here.
The enormous monetary and fiscal stimulus of the Covid period secured the most rapid bounce back the world has ever seen, from the steepest recession it has ever seen. The current pause is to be expected, a ripple from that storm.
The risk is that inflation, now ignited, proves harder to extinguish than we might hope. The pandemic stimulus packages drove aggregate demand up, and it remains above long-run potential aggregate supply (still scarred by Covid) in many countries.
That excess demand has provided the kindling for higher inflation, and Russia’s invasion of Ukraine has poured petrol on the inflationary fire.
The combination of slowing growth and rising inflation is a harsh environment for financial assets. Markets were brutal during 2022, punishing holders of bonds and equities alike. And right now the signals remain negative. For example, the put/call ratio in US equity markets is, on the face of it, more bearish now than at any time since the great financial crisis.
However, things are not as bad as they might seem. The recent reversal in the put/call ratio coincided with US Federal Reserve chair Jerome Powell’s hawkish position on rates and quantitative easing, which was effectively a removal of the free put option that the Fed had issued to markets from the crisis of 2008-09 onwards.
With that removed, market participants now have to pay for the same option, and that is what they are doing. It is possible that they were equally as bearish before rates started to rise, but felt protected by the Fed put. And the spike in this ratio also reflects technical factors, so it is not really as bearish as it looks at first glance.
It is prudent to take this signal into account when thinking about your asset allocation, but the outlook for equities is probably not as bad as this signal alone might suggest.
For a start, it turns out that the bearishness apparent in that ratio is not consistent with the news on corporate profits, which remain robust, especially as a share of GDP.