Six reasons why inflation may feel like gum on your shoe
The short answer is no. But following the collapse of Silicon Valley Bank and the Credit Suisse shake-up, markets are indeed behaving like all bets are off. Not only have they already written off the possibility of another hawkish rate hike next week counting on a more lenient Fed, but they are also celebrating inflation retreating in line with consensus expectations - with the exception for bank stocks that have been reeling from contagion fears. While the recent cracks in banking are certainly no reason to throw the baby out with the bathwater, we believe that caution is warranted.
As recent data has revealed, inflation might continue to retreat but let's all remember for a second that it remains elevated at 6% - way above central-bank targets. Plus, core inflation is still high and has even risen by 0.2% yoy. Core or “supercore” inflation is the measure that the Fed has chosen to be most important when deciding on its next moves. History from the 1980s has taught us that not finishing inflation off properly opens the possibility for it to creep back in which can have devastating effects on the economy1. While a 50 bps rate hike might be risky to impose on a wobbly US financial system, a 25 bps increase is definitely still reasonable given the Fed's commitment to wrestling inflation down. In a similar vein, the ECB seems rather unimpressed with recent events and remains firm on inflation pushing rates up by another 50 bps on yesterday.
As the lagged effect of recent policy tightening have started to bite into rate-sensitive sectors, such as real estate and now banks, it can be expected that investors will demand a higher risk premium for holding these titles going forward, unless we see a dovish policy pivot effectively materializing. True, SVB is a highly specialized lender confined to a certain regional space that does not have the power to destabilize the global system, like the “too-big-to-fail” banks did in back in 2008. Also true is the fact that many banks, including European ones, are much better capitalized than in the past which should enable them to navigate through unruly markets. So, what’s the problem then? Well, for one, interest rate volatility and the degree of interest rate sensitivity of some players and countries. The most obvious victims are already struggling lenders facing large unrealized losses on their balance sheets who might get caught in a downward spiral unleashed by negative market sentiment. Or embattled banks like Credit Suisse who have been facing a loss of customer confidence for a while. However, also financial systems in countries that display high sensitivity of mortgage rates to market interest rates, like Sweden or Norway for example, face some vulnerabilities.
The Fed has always said that bringing down inflation is likely to cause pain. With bank stocks reeling, we just got the first glimpse of what this might look like. Even if the Fed's decision-making process has now become more complicated due to the turmoil in the financial system, it is unlikely that it will take its foot off the pedal entirely. This is because the current market rout is unlikely to usher in a broad-based downward trend already now precipitating a global recession based on financial systems collapsing. This mild optimism is based on central banks’ swift action to protect depositors, thereby preventing bank runs and contagion risk. This has been the case for SVB and for Credit Suisse, whereas for the latter the government gave a guarantee for emergency liquidity measures. However, this should not be interpreted as an overall bullish market outlook. As we explained in a different article, we are likely experiencing a grace period which may last until the third or fourth quarter of this year which is when markets may have to grapple with reality that fundamentals have deteriorated beyond doubt and that interest rates are still inconsistent with the desired inflation decline back to target within the 2-year horizon. As inflation has not been a big concern for central banks for decades, investors currently cannot rely on any statistical evidence on how central banks weigh recession versus inflation risk which has made monetary policy highly unpredictable introducing additional volatility in the market.
Now is not the time to take risks. The shorter end of the yield curve is still one of the most appealing places to be right now as it has helped investors navigate this turbulent period. Hedging the 2-year exposure might not be a bad idea though since inflation is still the main priority of both the Fed and the ECB even if wobbly financial systems have moved the moment of a possible pause in rate hikes a bit closer. Equities in general look like a wild ride at the moment so decreasing exposure or hedging them is prudent. In that sense, increasing exposure to the safety factor can shield parts of the portfolio from excessive volatility. In comparison to equities, the risk premium offered on European investment-grade corporate bonds looks more appealing for the time being.
1. See our market update Six reasons why inflation might feel like gum on your shoe