You wouldn’t be alone in thinking the world has turned upside down. Not only is there a raft of local and geo-political issues that can have dramatic effects on financial markets, but the financial world has its own problems which are on scale commensurate with the political ones. Politics, markets, and economies are all blurring into one with a myriad of interconnecting effects. Not to mention a few current or potential wars. But hey, there’s always a list. There’s always a reason not to brazenly buy equities, the riskiest form of a company’s capital. In 2022 a few thundering thematics have emerged making one wonder how we got here. Much of this rests on interest rates and inflation.
Since the GFC, Central Banks (CB’s) in all major economies have lowered interest rates to stimulate economies. CB’s directly control the cash rate but can force longer term rates down by buying fixed rate bonds, pushing up the price which lowers the yield. Inflation was low over most of this century giving CB’s some room to move. After all, they all wanted some inflation, as the theory runs that it’s a sign of a functioning and healthy economy. However, this century deflationary forces have been at work; China’s rise as a cheap manufacturer, large technological advances in turn driving a more interconnected world, producing cheaper more efficient goods and services. Inflation was stable well under 2%.
Pre-covid short and long term interest rates in Australia were both at or below 1%. Forty-year lows! CB’s were at a loss how to keep economies stimulated. Then along came Covid, causing massive economic disruption that had CB’s stepping in again, lowering rates further; the cash rate to effectively zero in Australia and in most major economies. The idea was to get economies back on their feet. Covid unwound much of the deflationary effects of efficient global supply chains. Prices rose, the amount of people in the work force shrunk and much efficient manufacturing unwound. As economies rebounded, commodity prices soared, including oil which has a multiplier effect on prices, as it’s used in so many manufacturing and supply chains. CB’s claimed any inflationary effects were short term and related to supply chains. Rates remained low.
But a clash of concepts was not realised. CB’s were still talking the mantra that rates were to be lower for longer. This gave consumers, investors, and corporations confidence to spend or invest. Inflation readings rose. Over 12 months a massive stimulation of economies just led to more inflation. Economies weren’t just back on their feet they were running, especially consumer demand. In 2022 inflation jumped to over 6% in most advanced economies. By mid-2022 on every measure inflation was exploding. CB’s finally acted with unprecedented quick rises in cash rates and eventually a cessation of the long-term bond buying. But the horse had bolted. Only in past months have inflation readings levelled off. No falls yet. A CB’s main tool to lower inflation is to slow the economy via higher interest rates. It’s a blunt tool. In theory a slower economy should lead to less demand which should lower prices. However, in an impatient world there are two problems. Firstly, higher interest rates take time to have their effect, creating a conundrum for CB’s; wait for the effects or keep acting? Given their recent reading of the situation I wouldn’t be confident if I was them. Secondly enter politics. In a time of popularist politics, what government wants their economy slowed let alone potentially smashed? These two forces clash. Witness the fiasco recently in the UK when the government announced stimulatory measures just as the CB was raising rates to slow the economy! Financial markets run on confidence. Such an event kills confidence and investors flee. Not just in stocks but in bonds – unfortunately the funding instrument for all governments. Currencies get sold off. A mess.
The problem is things are complicated. Our interconnected world escalates cause and effect. A positive effect sought by one action can have a negative effect elsewhere, some of which are unknown. And then there’s how the actions of one county affect another. We haven’t even touched on the rise of the USD or government mounting deficits. So, it’s a long list with lots of stars. Lots of intertwining factors to play out. But rarely it turns out as expected. Hopefully in 2023 some on the list can be crossed off. That would be good, as right now all on the list have a bad side.
