A fortnightly look at global financial markets

• A trendless market, but investors retain a risk appetite

• Stock markets benefit from reasonable valuations and lower bond yields

• The bank crisis, and oil production cuts, confuse the inflation picture

• Inflation: tax payers vs bond holders

Market sentiment: Trendless. Investors, like central bankers, face a confusing array of issues that will impact on stock, bond, and cash returns. However, the strong performance of U.S tech stocks in March indicates that investor risk appetite has not been diminished by the recent bank crisis. The likelihood continues to be for a new global economic cycle to start late this year, when the Fed begins to cut interest rates. 

Given the large sell-off seen on many stock markets last year, stock market valuations are not stretched (indeed, in the U.K share prices look cheap on most measurers). This, together with the recent fall in bond yields in most major markets, gives stock markets protection should troubles emerge elsewhere in the financial system over the coming months. 

In view of the multitude of issues facing investors, a diversified, multi-asset portfolio that purposely limits exposure to any one particular asset class looks like the best approach. Financial history demonstrates that such a portfolio tends to deliver the best returns relative to the risk (ie, volatility) taken.  

What are the confusing array of issues? Prior to the March bank crisis, it was said that central banks faced a dilemma. They can raise interest rates quickly, to bring down inflation, and risk a recession (some described the risk as that of ‘killing the patient you are trying to save’). Or they can protect economic growth, by taking a more gradual approach to interest rates, and risk inflation becoming embedded through higher wages. The approach taken has different effects on asset classes; after a slow start the major central banks took the aggressive approach from last March, leading to falls in stock and bond prices over the year.

Central banks now have a quadrilemma (how else to describe two additional dilemmas?!). The bank crisis, and the decision by OPEC+ to cut production by 1.1 million barrels per day (p/d), must also be taken into account as they wrestle with the problem of when to stop raising interest rates. But are these deflationary problems, or inflationary?

Bank crisis adds complexity. The Fed has argued that the recent bank crisis is potentially deflationary, as banks become less willing to lend and anxious to harbour cash. Jay Powell, chair of the Fed, has implied that interest rates may not have to increase as much as previously expected, because of this.

But if the response to the recent crisis, and presumably any further problems to emerge, is to shower the financial sector with liquidity, to prevent a systemic crisis emerging, then central banks are in a curious position. They are tightening monetary policy with one tool (interest rates), while easing it with another (emergency cash injections into the financial system). 

Can a central bank manage both a financial crisis and an inflation shock at the same time? If that isn’t migraine inducing…

OPEC+ bring further problems. On Sunday Saudi Arabia agreed to cut crude oil production by 500,000 p/d, along with 600,000 p/d reductions in output from other members of the OPEC+ group of oil producers. Nervous of falling prices, as the outlook for global growth weakens, the group wants to stabilise prices by reducing output. This led to an immediate $6 jump in Brent, to $86, and oil stocks around the world rallied. Goldman Sachs have a new price target of $95. Is this inflationary, or deflationary?

Higher energy costs risk raise headline inflation, and yet discourage economic activity, and so are deflationary in the medium term. When energy prices began rising in 2021, central banks argued that, since they could do little to affect the oil and gas price, it was pointless raising interest rates in response. To do so risked exacerbating the downturn in economic activity that higher energy costs bring. If we do see energy once again become part of the inflation problem, will the central banks stick to that line? 

The problem is that last time the inflation shock lasted longer, became broader, and was more severe than expected (exacerbated by lock-down induced supply side bottlenecks). But if central banks claim that they have learnt lessons from 2021/22, and raise rates in response to higher energy prices, investors may fear monetary over-kill - and a perhaps severe recession. 

Inflation: taxpayers vs bond holders. Inflation can help the tax payer, in the broadest sense. The IMF, in its latest Fiscal Stability report, has highlighted the benefit to government finances of inflation. To the individual tax payer, inflation can feel exploitative. Governments often respond by not raising allowances in line with prices, so taking more tax revenue through the process named fiscal drag. But the IMF has highlighted how the inflation of recent years has benefited the tax payer in the general sense, to the cost of bond investors. 

First, inflation lifts the nominal GDP of a country, but the amount of outstanding government debt is unchanged. This helps reduce debt to GDP ratios, which have fallen from 99% in 2020 to 95% in 2022, and in Italy from 142% to 135% over the same period -despite the large increase in budget deficits to pay for the Covid pandemic. Lower debt to GDP ratios allow for more borrowing in the future, should the need arise, without markets becoming unduly anxious. 

Second, while tax revenue is lifted through fiscal drag, government spending is less sensitive to inflation, and takes time to catch up. This is illustrated by the public sector strikes taking place in the U.K at the moment: many are striking to have their real wage restored to what they were in 2010, before a decade of wage restraint and, more recently, a bout of high inflation, ate into their real value. 

These are, however, one-off gains. Bond investors have now adjusted their interest rate expectations and are demanding more interest, adding to the cost to the government of running large deficits. And public sector workers are becoming militant, often with the support of the general public, forcing -in the U.K at least- some compromises by the government.

Stay well!