Real returns have been easy to come by for the past decade, with most asset classes delivering well ahead of inflation.
That does not mean there is no more pain to come, but markets are effective discounting mechanisms and have already adjusted significantly to the realities of lower growth and higher inflation in the near term.
At the start of 2022, consensus expectations pointed towards inflation in many major economies falling back towards target during the year, but the supply shock to energy and commodity markets of Russia’s invasion of Ukraine extended the upward pressure on prices, while also damaging the growth outlook.
That explains much of the weakness in equity and bond markets since then, while true to form, real assets have held up much better.
However, while growth is likely to remain weak and inflation high for several months to come (at least) the key question is around how long these conditions will persist.
Uncertainty cuts both ways; will the slowdown in growth be less acute than feared and will inflation fall faster than expected? These are critical factors that are incredibly difficult to judge; consider how central banks have all but abandoned their forward rates guidance and moved to a more data-dependent, meeting-to-meeting approach, because they face such a dynamic and uncertain situation.
Concerns around the prospects of a 1970s-like period of stagflation are no doubt valid, but there is every chance that will be avoided.
Here in the UK, the Bank of England has forecast inflation to reach more than 13 per cent this year, but if commodity prices continue to fall – as has been happening in recent months, driven at least in part by growth fears – then CPI will undoubtedly come down, as we have already seen in the latest print in the US.
Slowing consumption, tightening financial conditions and more normalised supply chains globally will also exert downward pressure.
Also, the more important measures to focus on are core inflation, a less volatile series that better reflects more sticky components of inflation, and wage growth. These reached much higher levels in the 1970s, reflecting a more persistent and troublesome sort of inflation, with wage-price spirals and high inflation expectations, which we are not yet seeing today.
However, until inflation starts to decelerate in a sustained way, risks of this sort of vicious inflation cycle becoming entrenched remain significant.
History tells us that once the inflation genie is out of the bottle it can be very difficult to contain it again. Policymakers face the considerable challenge of bringing inflation back down to target without triggering a slump in growth, which is already under pressure from supply shocks. The risk of error is high.