Forget ‘soft landing’: Global market rally is sowing the seeds of its own destruction

The current surge in market sentiment is driven by conflicting and irreconcilable forces – an improving outlook will spur inflation, which will lead central banks to raise, rather than lower, interest rates

Nicholas Spiro

Published: 10:00pm, 9 Feb 2023

Why you can trust SCMP

Has inflation peaked and will interest rates come down by the end of this year? This has been the question on the lips of every investor since a fierce rally in markets took hold at the beginning of this year. With inflation still running hot around the world and leading central banks continuing to raise rates, speculation about lower borrowing costs seems woefully premature.

However, markets are forward-looking and see light at the end of the monetary tightening tunnel. What is more, investors are more optimistic about the outlook for global growth, heartened by the unexpectedly rapid reopening of China’s economy and the dramatic fall in wholesale gas prices which has provided a major fillip to Europe’s economy.

In the space of just several months, the market narrative has shifted from a rising inflation-collapsing growth environment to a declining inflation-improving growth one. This has provided ammunition for those betting on a “soft landing”, whereby inflation is brought under control without causing a full-blown recession.

Every major asset class, with the exception of the US dollar and commodities, has delivered positive returns since early January, which is a stark contrast to last year’s bloodbath.

In a sign of the degree to which sentiment has improved, some of the riskiest assets – “junk” bonds, “meme stocks” championed by retail investors on social media and even bitcoin – have enjoyed a huge bounce.

In a report published last Sunday, Morgan Stanley noted that, “across assets, it has been one of the strongest starts to a year in recent memory.” Yet, as is often the case in markets, asset prices overshoot in response to changes in economic data or shifts in policy, especially ones open to interpretation.

Pedestrians on a Beijing overpass. The unexpectedly rapid reopening of China’s economy has helped brighten the outlook for growth. Photo: Bloomberg

The current rally, however, is not just overdone. It is driven by conflicting and irreconcilable forces that are sowing the seeds of its own unravelling. It also leaves markets and central banks dangerously far apart on the outlook for inflation and interest rates, which is a recipe for further volatility in the coming months.

While headline inflation is coming down from the multi-decade highs reached following Russia’s full-scale invasion of Ukraine, prices remain far above central banks’ targets. More worryingly, core inflation – which strips out volatile food and energy prices – is proving “sticky”.

This is especially true in the services sector, which is tied to the labour market. Data published last Friday revealed that the US economy added more than half a million new jobs last month, allaying fears about a recession.

Markets are choosing to focus on the positives. Inflation has passed its peak and is slowing, while economies are holding up better than expected. For bond investors, this means rates will soon peak and eventually start to come down. For equity investors, this means a reassessment of the prospects for growth and a fillip to valuations, particularly those of battered technology companies.

Yet, there is a glaring inconsistency in the “soft landing” narrative driving asset prices. If the outlook for global growth has improved, making it less likely that inflation will drop sharply, why would central banks end their rate-raising campaigns in the coming months and even start reducing borrowing costs before the year is out?

The sharper the rally in markets, the more difficult it becomes to tame inflation. Surging asset prices are inflationary because they loosen financial conditions, making it easier and cheaper for firms to raise money and making households feel richer. The reality is that investors are shooting themselves in the foot by ramping up bets on falling inflation and stronger growth.

Second, central banks themselves are partly to blame. Their forward guidance is unclear and prone to misinterpretation, increasing the scope for a mispricing of risk. While the US Federal Reserve and the European Central Bank say further rate increases are required, they also emphasise that much of the heavy-lifting has been done, suggesting the rate-raising cycle is about to come to an end.

While all major central banks are walking a tightrope when communicating with markets – particularly the Bank of Japan, which is still debating when and how to exit its decade-long ultra-loose monetary policy – the challenge facing the world’s most important financial institution is the most acute.

A screen shows coverage of a speech by US Federal Reserve chair Jerome Powell about the state of the US economy on the floor of the New York Stock Exchange on Tuesday. Photo: EPA-EFE

Fed chair Jerome Powell has so far made little of the fact that investors’ expectations regarding inflation and rates are overly optimistic, leaving the US central bank open to criticism that it is not doing enough to engender the tighter financial conditions necessary to help quell inflation.

This is debatable, especially since it is not central banks’ job to target asset prices directly. What is clear, however, is that bullish investors cannot have it both ways.

A stronger-than-expected global economy obviates the need for rate cuts any time soon, especially if China’s reopening ends up fuelling inflationary pressures more sharply. On the other hand, if bond markets are right and central banks start lowering borrowing costs later this year, this would be because growth collapsed or a financial crisis erupted.

The path to lower inflation and lower rates will not be smooth. A “hard landing” is not preordained, but a soft one is wishful thinking.

Nicholas Spiro is a partner at Lauressa Advisory

Post