Markets are in 'things couldn't be worse' rally

The 1973-74 bear market was a brutal one as investors worried about rising inflation and faltering economic activity, exacerbated by OPEC’s decision in October 1973 to stop oil exports to the United States.

Move in key steps

US blue-chip stock market index, S&The P 500, fell 42.6 percent in the 21 months ended September 1974.

Fast forward nearly half a century, and investors are once again spooked by rising inflation and stagnating economic activity.

S&The P 500 index fell 20.6 percent in the first six months of 2022, its worst first-half performance in more than 50 years.

Since then, however, financial markets have strengthened strongly, with the prices of stocks, bonds and cryptocurrencies posting impressive gains.

Since hitting its lowest point on June 16, S&The P 500 has gained 12.6 percent, while the tech-heavy Nasdaq has gained 16.4 percent.

The only plausible explanation for this rally is that – like Corrigan – investors have formed the view that it is time to get back into the market as things can’t get any worse than they already are.

And this implies that investors expect global inflationary pressures to quickly bend under the string of rate hikes that have been unleashed by the world’s major central banks.

After all, central banks in developed economies – such as the US Federal Reserve, Bank of Canada, Reserve Bank of Australia, European Central Bank and Bank of England – are now moving in unison as they raise interest rates to cope with rampant price increases.

This historically unprecedented synchronized monetary tightening will no doubt reduce global demand, which will take a lot of the heat out of inflation.

Indeed, there is a grave risk that these synchronized rate hikes will cause economic activity to contract too sharply, plunging the global economy into recession.

Already, investors are becoming optimistic that the US central bank – which has raised rates at its fastest clip since former Fed chairman Paul Volcker conquered double-digit inflation in the early 1980s – is nearing the end of its tightening cycle.

Signs of a successful attempt

The Fed raised its interest rate target by 75 basis points last week, bringing the official interest rate to a new range of between 2.25 percent and 2.5 percent. At the start of the year, the Fed’s policy rate was close to zero.

While it will take time to feel the full effects of these rapid rate hikes, there are signs that they are already weighing on demand, which should help reduce inflation.

The US housing market is deteriorating, consumer spending is falling and retailers are offering heavy discounts to clear surplus stocks, indicating the Fed’s efforts to rein in household spending to slow inflation are successful.

Investors also expect that falling commodity prices will reinforce this downward inflationary pressure.

Commodity prices are also under pressure, both from a darkening global growth outlook and from a surge in the US dollar.

As most commodities are priced in US dollars, a stronger greenback makes them more expensive for non-US buyers, which helps curb demand and depresses prices.

Commodity prices surged earlier this year, as production struggled to keep pace with the global economic recovery from the pandemic, and after Russia’s invasion of Ukraine triggered a spike in oil and gas prices.

But prices for oil, metals and agricultural products have fallen sharply since early June, and this will push official inflation figures lower in the coming months.

Investors cheered last week when Fed chairman Jerome Powell acknowledged there were signs that rate hikes were starting to bite, and that future rate hikes would likely be smaller.

This was confirmed by the Fed which downgraded the state of the US economy. In a statement released after its June meeting, the Fed said “overall economic activity appears to have picked up”.

The statement released after last week’s meeting noted that “expenditure and production indicators have recently softened”.

Not so neutral

However, some analysts believe that investors are too early to bet on a dovish pivot by the Fed.

They point out that US private sector wages and salaries jumped 5.7 percent in June from a year earlier, which should continue to put pressure on prices, particularly in the services sector.

What’s more, they point out that although the US housing market appears to be cooling, rents lag behind house prices by about a year. As a result, the cost of housing, which makes up about 40 percent of the US consumer price index, is likely to continue to rise sharply into next year.

Analysts also believe that investors were wrong to take comfort in Powell’s comments that US interest rates are now near “neutral” levels, where they do not limit or spur economic activity.

Investors interpreted Powell’s remarks as further confirmation that the Fed is nearing the end of its monetary tightening cycle.

But many economists are skeptical that the Fed is close to reaching a “neutral” rate.

Former US treasury secretary Larry Summers attacked Powell’s assessment that the US official interest rate was close to neutral, saying it was “analytically untenable”.

In an interview on Bloomberg Television on Saturday, Summers said: “There’s no way the 2.5 percent rate, in a bubbling economy like this, is anywhere near neutral.”

He added that he was concerned the Fed was still engaged in “wishful thinking” about how much it would take to bring inflation down from a four-decade high.

The lively rally in financial markets over the past six weeks suggests that investors are more than happy to join the Fed’s “wishes”.

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