At Jackson Hole, any lingering hopes for a swift dovish pivot by central banks due to a deteriorating growth outlook were finally wiped out as US Fed Chair Jerome Powell re-confirmed his priority of bringing down inflation over keeping growth afloat. In response, markets tanked and put a firm end to what we can now all agree was a mere bear market rally over the summer months. Now, it is time to focus on risk in portfolio construction and resort to assets that offer some shelter from higher volatility levels as markets will likely grapple with higher uncertainty as we transition to what might be a new market paradigm.
Markets just underwent a harsh reality check. If they were counting on renewed rate cuts in early 2023, they are now not expecting any before 2024. Even if US inflation is showing the first signs of retreat from its latest peak numbers, the main question now is if it will become ingrained in higher wage growth and higher rents. Once it does, it will be hard to get rid of. This is also why Powell’s tough love mainly targets people’s expectations on inflation: once people start factoring in higher inflation into their daily consumer behavior as well as corporate decisions, the fight against inflation will be a lost cause, and above-target inflation numbers could become the new norm. Therefore, remaining firm on inflation is essential for the Fed to maintain credibility and demonstrate its ability to make a dent in supply-side driven inflation - which is already a hard enough job to do as it is.
On the old continent, credibility may prove to be the ECB's weak point in managing inflation as Christine Lagarde has had to face accusations of prioritizing defragmentation over price stability when the central bank announced the introduction of a targeted bond buying program to avoid financial fragmentation across the European Union. Even if the ECB plans to remove the additional liquidity that the program introduces by other means, potential inflationary effects cannot be ruled out. Having said that, the ECB has a tough job as it has to keep together a pretty heterogeneous bunch while bearing the lion share of the burden of the Russia-Ukraine war as well as the toxic effects of its dependence on Russian gas supplies. Nevertheless, an aggressive rate hike by the ECB of 75 bps can be expected at its next policy meeting today - a much needed move in a bid against soaring Eurozone inflation that just hit 9.1.% in August. Going forward, the ECB's inflation management abilities will largely hinge on the degree to which the European political agenda will be allowed to influence monetary policy. Therefore, Europe’s inflation trajectory carries significantly more risks and uncertainties compared to the US's.
As price stability takes priority over growth for central banks, we might be on the cusp of a new market environment – one that could be characterized by higher inflation and higher volatility than we are used to. As the transition unfolds and uncertainty remains elevated, further bear market rallies, like the one we have seen recently, are likely to make a more frequent appearance. Therefore, risk management in portfolio construction and active management should be front of mind for investors. Due to diverging monetary policy paths, European equities currently carry more risks than their US counterparts. Whereas bonds of longer duration might not be the best bet at this moment in time due to higher interest rate sensitivity, short-term bonds of core European governments and the US may offer some shelter as their prices have already largely absorbed expected future rate hikes.