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The US Federal Reserve building in Washington on December 15, 2021. The Fed has been accused of ignoring rising inflation for too long, setting up equities markets for a nasty fall when interest rates eventually rise. Photo: Xinhua
Opinion
The View
by Richard Harris
The View
by Richard Harris

Expect a year of shock and recovery as interest rates and prices rise

  • The stock market will fall once the Fed finally raises rates, but it is not yet time for the next big monetary collapse
  • While there are many reasons to be cheerful, events are still building to a crescendo of worsening conditions in 2023
Richard Harris
Richard Harris
Why you can trust SCMP
It is a truth universally acknowledged that the stock markets will take fright at the first whiff of interest rates rising. This year might well prove that wrong as the two prize fighters, interest rates and inflation, duke it out.

As with any sporting contest, fortunes will ebb and flow. That could lead to investors getting whiplashed as we don’t know when the first knockdown will come.

The eventual winner might not be known this year, but whoever it is will dominate financial narratives for the next few years and radically change the kind of investments that should be held.

The decisions to be taken this year by the US Federal Reserve Board are at the heart of all investment thinking. It has proved surprisingly stubborn in the face of reality, fighting against raising interest rates while fearing the economy is too weak.
Rates have been too low for too long, but the board would lose face if it admitted that inflation is high and rising – something its low rates have encouraged. Its aim is to support the economy, yet it provides easy money to rich people worried about share prices. The policy of zero interest rates has ruined traditional rational investment relationships because it was irrational in itself.

What’s driving the Fed’s modest approach to raising interest rates?

US politicians have consistently appointed economists to the Federal Reserve Board, when everybody knows that economists drive using the rear-view mirror. They should be appointing bankers or investment managers to the highest levels of the central bank as their whole careers depend on looking ahead. They need to have some guts with their forecasting, even if sometimes that is actually just indigestion.

In essence, we cannot expect leadership from the Fed as it continues to lag behind the real world, keeping rates low while pretending that inflation is not running out of control. The degree of fright at the first whiff of interest rates rising will depend on how severe the rises are.

In behavioural terms, the best thing for the stock market is for the Fed to increase rates frequently by small amounts – the “frog boiling” strategy. Shares will suffer in the short term, maybe falling as much as 20 per cent. They will not suffer as much the next time rates go up, though, and the market is likely to recover from those lows.

Unfortunately, gradual rate rises take time and November’s US consumer price index inflation came in at 6.8 per cent. If inflation stays high, the market might think that we don’t have time and we could see a bigger fall.

Analysts do not have the luxury of being as wishy-washy as the Fed and must put their views on the line. My core assumption this year is that inflation is going up and will be closer to 5 to 6 per cent, rather than the hoped-for 2 to 3 per cent, by the end of the year.

It is the result of most central banks around the world having lost control of money supply. They have been quite happy to print cash to defer the upcoming “Greatest Recession” for just a little longer.
Higher inflation will probably be good for many equities, even if the bond markets are going the other way. When bond prices fall, interest rates normally rise and equities prices fall.

They should go up and down together since interest rates can be a big cost to business. This time is different, though. The normal bond-equity relationship has not held since at least 2018.

Investors in equities actually have several reasons to be cheerful. Inflation helps company earnings, which are typically not quoted in real terms and will be perceived to be going up, provided the company can continue to raise prices.

The massive liquidity stemming from support provided during the Covid-19 pandemic is still running through the financial system. There is no indication central banks won’t print money again if the economy is threatened.

With inflation on the way, consumers are likely to buy now before prices go up, helping the global economy by borrowing consumption from next year. The big positive is that real interest rates will be so low that people will borrow because cash is losing money and assets seem a better bet.

The timing of the first punch is anybody’s guess. It could land in January, June or any time. The stock market will fall, but it is not yet time for the next big monetary collapse. If prices rise much more before the fall, investors won’t mind so much.

This year is therefore one in which we should expect a shock but also some recovery. It will mean investors holding their nerve. We might still be partying as if it’s 2021 – there are too many reasons to be cheerful, but events are building to a crescendo of worsening conditions in 2023.

What we do know is that markets do not tread water – the twin factors of greed and fear means they go up slowly and come down quickly. Fasten your seat belt and play the long game.

Richard Harris is chief executive of Port Shelter Investment and is a veteran investment manager, banker, writer and broadcaster, and financial expert witness

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