As we moved into the final quarter of 2021, we at Punter Southall Wealth felt strongly inflationary pulses would set the tone for markets through the remainder of this decade.
What was interesting was that at the end of last year, even though headline inflation rates screeched higher through 5 per cent in the UK, US and Europe, markets simply didn’t care.
Traditional market sensitivities to inflation went into reverse and left us scratching our heads as to why the expected patterns failed to appear.
Part of the answer was, again, liquidity: there was so much money sloshing through markets that no inflation-sensitive asset sold off.
The other factor was timing, and it is obvious that the inflationary impact upon markets was delayed, with the start of 2022 being grim for those normally negatively exposed investments (such as long-duration government bonds and expensive growth equities) that performed surprisingly well in the inflationary conditions at the end of 2021.
If we are right and inflation is the fulcrum for financial markets in the period ahead, what happens next? Our view remains that inflation will remain higher than we have become used to in the post-financial crisis years since 2008. Wage settlements are comfortably higher, price pressures in supply chains persist and commodity prices remain elevated.
In the short term, however, we are questioning whether we will see a whole year of inflationary angst, as there should be some soothing of inflationary pressures as we progress through 2022 – which does raise questions over whether central banks are right to be suddenly talking tough on inflation.
Of course, there is a major difference between threatening to tighten monetary policy, as the US Federal Reserve and Bank of England have done, and aggressively following through with action.
Financial markets and the central banks in the US and UK are implying we will see three rate increases this year, leading to interest rates finishing the year on both sides of the pond at around 1%.
Such promised levels are way below anything we experienced before 2008 and hint at how much has changed in a slower global economy, which has become choked by extremely high debt levels.
But, given how addicted to ultra-low rates and monetary support our hyper-financialised economies and investors have become in the last few decades, we are far from sure that any sustained tightening of monetary policy will be achievable.
Can the global economy survive through a period of cold turkey? Will markets roil up at the retraction of the abundant liquidity constantly served up in recent years by the central banks?
At this point, we just don’t know, so we cannot project what effects might take place when the “punchbowl” is removed; but we do know this will be different to the easy money environment of the last three years.
We also worry this new direction of monetary policy might just be about to take place as the economy starts to slow back towards trend growth levels, as the early recovery from Covid-19 starts to fade.
Interestingly, nobody else appears particularly that worried about economic activity: the clear expectation is the economy will be vibrant in the year ahead.
We agree the start of the year will see a continuation of the healthy recovery of 2021, even if the headiest days of this cycle are behind us.
But as we come towards the second half of the year, we are concerned consumer and corporate pent-up demand will be exhausted and inventories will have been restocked, just as both the fiscal and monetary impulses neutralise or go into reverse.
As we have written before, such fears about stuttering growth could be allayed by a virtuous investment cycle by companies with higher levels of capital expenditure, but this is something that has been promised for more than a decade, without ever really materialising.
As we look towards the end of the year and the start of 2023, our base case is for levels of growth not wildly different from the low and slow pattern of the last decade, albeit with higher inflation uncertainty.
If we are right and the consensus is too optimistic then this could provide a nasty wake-up call for investors and calls into question whether the central bankers really can normalise interest rates to tame inflation.
Tim Wishart is head of Scotland and the north of England at Punter Southall.