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Inflation’s back, markets react

Regular readers of my column may recall that I pondered upon the alleged death of inflation. Despite enormous liquidity pump­ed into the financial markets by the world’s central banks and interest rates falling into deeply negative territory, and notwithstanding the fact that asset prices like real estate, stocks and bonds were inflated into the stratosphere, most econo­mists and financial pundits declared the death of inflation and an era of unprecedented calmness of the markets.

The new fear after the Great Recession of 2008, which had brought the eurozone almost to its knees, was deflation – a world where things would only get cheaper by the day and enterprises would struggle to make their businesses grow again (they grew regardless, making ever higher pro­fits). Even crude oil, the devil behind inflationary shocks in the past, seemed a paragon of new moderation.

I argued that as long as nobody really knew exactly why inflation had seemingly disappeared into thin air (contradictory theories abound), it was premature to jump to finite conclusions.

By definition, what looks like inflation is never inflation so long as wage demands don’t come to the fore – the moment when central bankers will ruin the party by aggressively raising interest rates.

Well, this moment has finally arrived. At the beginning of February we learned that US wages in the previous month had grown at the fastest rate in nearly a decade and that the mighty German trade union IG Metall, representing 900,000 workers and a yardstick for most salary agreements in the country, gained a 4.3 per cent wage rise starting in April as well as succeeding in their demand for a 28-hour week – something not even French 35-hour-idlers have ever clinched from their employers.

That the Trump outfit had slashed tax rates for corporations at the end of 2017 seemed now ill-timed, only goading the Fed to raise rates faster.

Investors were stunned. After years of soothing calm, the US Standard & Poor’s stock index had suddenly dropped nine per cent from its January peak, with European and Asian bourses following suit shortly afterwards. Prices for 10-year US treasuries fell, driving interest rates higher to then shortly reverse course as safe-haven buyers started to take refuge in government bonds.

Investors had no idea if this presented a buying opportunity or if it was the beginning of a rapid march into a formid­able crash. When you read this you will have already entered a new world of ups and downs.

What does this signify for us retail investors? A stock market crash is not only the consequence of unexpected financial haemorrhage, it is wealth-destroying and therefore damaging to consumption, an impediment to new investment and harmful for the economic activity of all stakeholders: pensions are at risk, tax revenue will fall, and companies will struggle to raise finance. In an interconnected world, everything will catch the flu, from commodities to countries, from banks to the man in the street.

It seems unlikely that February 2018 will be the time when the markets finally started their march into the abyss

Should we then sell everything and wait until in years to come we will again enter a new calm with asset prices rosily recovering?

First, it is far from clear what really happened. The ‘bull run’ after the financial meltdown of 2008 was never quite em­braced by investors. Many still stood on the sidelines waiting for the next catastrophe to happen, while share prices tripled.

Second, the sharp drop experienced over two days in February was predominantly caused by ‘momentum’ investors, hedge funds who speculate on trends calculated by inscrutable algorithms acting autono­mously. Once the direction is reversed such programmes rush for the exit gates, no matter what.

The main culprits were funds investing in the so-called VIX index, a measure for market volatility. These funds were making big money selling insurance to the faint-hearted. As their investment robots were self-driving into the ditch, they were immediately followed by those investors who had seen the bad thing coming – for the last 10 years.

Third, many bullish (optimistic) investors welcomed the price decline as a long over-due correction, proving the recovering health of the markets. For too long every asset class was a one-way bet with the central banks loading the dice. Risk pricing could finally make a return, rewarding those who can read a balance statement.

Fourth, volatile markets will put the economic performance of individual companies to the fore. Some companies will do better than others, picking champions will become a more profitable strategy than just passive investing in indexes.

Fifth, as I have explained in a previous column, it is impossible to foresee a high point after which prices will inexorably fall, just as it is impossible to predict the point in time when fortunes will recover. Yet, moving in and out of stocks is a sure recipe for guaranteed losses, fee expenditure not even taken into account.

Sixth, after one of the longest, if unloved, bull runs in history we are closer to the next crash than to the previous one, but how close nobody can tell. If we sell now we may lose out to a glorious finishing lap, cushioning investment injuries to come.

Seventh, the world economy is in a healthy state and growth is accelerating, in the developed as well as in the developing world. This is the reason why unemployment is falling and wages are rising. It seems unlikely that February 2018 will be the time when the markets finally started their march into the abyss.

Eighth, for many industries, rising inflation as well as rising interest rates is a blessing: think of banks, pension funds and insurance companies.

Ninth, rising inflation will mean rising commodity prices; miners and big oil will profit, as will those countries that export commodities.

And finally, in times of rising volatility and seesawing markets, arbitrage opportunities will pop up as well as many buying opportunities.

This said, a word of caution: when volatility and nervousness is on the rise it is certainly not a good idea to stay fully invested. In times of approaching trouble, cash will be king.

What do they say?

Stay calm and carry on…

Andreas Weitzer is an independent journalist based in Malta. He reports on the economy, politics and finance. The purpose of his column is to broaden readers’ general financial know­ledge. It should not be interpreted as presenting investment advice or advice on the buying and selling of financial products.

Please send in any suggestions for discussion in this column to: editor­@ timesofmalta.com – Subject: Sunday Times Personal Finance.

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