The Federal Reserve building in Washington, on Jan. 26, 2022.JOSHUA ROBERTS/Reuters
Stock markets in Canada and the United States gained this week, but don’t mistake that for evidence of Zen-like calm.
Investors spent the latter half of the week eviscerating high-profile performers that came up short of analysts’ expectations for earnings. Meta Platforms Inc. (formerly known as Facebook) and PayPal Holdings Inc. both lost more than 20 per cent of their value overnight.
The abrupt fall of these stocks – as well as the recent smackdowns of Netflix Inc. and Spotify Technology SA – demonstrate how quickly many of the darlings of the pandemic economy are losing favour. But the slowdown in their earnings also underlines concerns about what lies ahead for the broader economy.
It’s not that things are falling apart. Just the opposite: Aside from a handful of big-name misses, corporate earnings have generally been solid and wage growth impressive. But what comes next, as the economy transitions away from pandemic-era stimulus and rock-bottom interest rates, looms as a gigantic question mark.
Stimulating the economy was easy. Taming inflation will be much trickier.
It’s painful. But the sooner we reduce inflation, the better
The biggest mystery of all is how central banks – especially the U.S. Federal Reserve, the world’s most powerful central bank – will respond to the highest inflation readings in decades. A number of prominent observers are warning the Fed has been so late to the inflation fight that it may now be forced to hike interest rates to brutal levels and engineer a market-rattling recession to bring prices back to earth.
The Fed did this back in the early 1980s when inflation was ripping. With inflation once again hitting multidecade highs, a repeat performance can’t be ruled out.
Tim Duy, a prominent Fed watcher and chief U.S. economist at SGH Macro Advisors in Connecticut, reminded his newsletter readers this week that “historical data indicates that inflation trends do not reverse without the help of a recession.”
Martin Wolf, the much-honoured economics sage at the Financial Times, issued a similar warning. In his column, he thundered that the Fed’s benign forecasts are “bewildering.” He concluded that the Fed’s goal of corralling inflation will be “extremely hard to pull off” without inflicting a recession.
Bridgewater Associates, the giant U.S. hedge-fund operator, put much the same message in more technical terms. In its most recent forecast, it warned that many investors are blithely assuming inflation will slide tamely back to its prepandemic level “without the need for aggressive policy action.”
Bridgewater doesn’t agree with that complacency. It is braced for fireworks if, as it expects, reality disappoints the market’s hopes for a painless return to normality. It sees major rate hikes ahead and “the potential for large market moves, which of course implies significant risks from holding assets.”
Consider yourself warned. The tricky thing, though, is figuring out whether the possibility of a nasty rate-hiking cycle merits overhauling your portfolio.
Maybe not. John Higgins, chief markets economist at Capital Economics, says rising government bond yields will cut into returns from risky financial assets, such as stocks, but he doesn’t expect a crash. “We forecast reasonable returns from most risky assets between now and end-2023, given our positive assessment of the economic outlook,” he wrote this week.
To be clear, it’s not that Mr. Higgins is wildly optimistic about what lies ahead. He expects U.S. stocks to advance only about 4 per cent a year over 2022 and 2023. For global stocks, he sees gains of about 5.7 per cent annually over those two years. Nothing too exciting, in other words.
His point is simply that stocks don’t have to do much to beat the dismal yields that bonds are offering. So long as bonds continue to destroy wealth after accounting for the corrosive impact of inflation, investors have little choice but to stay invested in stocks. It would require a major rise in interest rates to hurt the appeal of stocks by making bonds a truly attractive investment destination once again.
So is there much chance of such a rate rise occurring? Many economists argue that today’s ultralow interest rates are wildly inappropriate for countries such as Canada and the United States, which have enjoyed rip-roaring recoveries over the past year. If the boom continues, they are absolutely right.
However, it is not clear whether the boom will continue now that governments are withdrawing their pandemic support programs. The Federal Reserve Bank of Atlanta’s GDPNow estimate of current activity indicates the U.S. economy is creeping ahead at a mere 0.1-per-cent clip in the first quarter. If that reading proves accurate, it is hard to imagine the Fed bringing down the hammer with an aggressive series of rate hikes.
Investors may want to keep an eye on the yield curve for clues about what is to come. The gap between the yields on 10-year Treasuries and two-year Treasuries serves as a rough guide to expectations – a large positive gap indicates optimism, while any reading below zero has been a reliable indicator of a U.S. recession ahead.
The gap has been narrowing in recent months, but is still far away from zero. For now, anyway, the message seems to be that the good times will continue. At least until the Fed says otherwise.
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