In the autumn of 1997, both in Europe and the United States, the ten-year interest rate fell towards 5 per cent. This was caused by the Asia crisis, which caused prices to fall worldwide. Falling interest rates and falling share prices were an unusual combination at the time.
For more than 30 years - from the mid-1960s to 1997 - falling interest rates actually caused rising prices on the stock market, just as rising interest rates at that time put pressure on the stock market. So there was a negative correlation between the stock market and the interest rate. Since 1997 the correlation between equities and interest rates has been positive, but that is about to change.
Prior to 1997 inflation was seen as the main risk for the economy and financial markets. Since 1997, the focus has been more on the risks of deflation, partly in combination with high debt levels. Falling Asian currencies, including the devaluation in China in 1994 and the crash of the Mexican peso at the beginning of 1995, enabled local producers in those countries to lower their prices in dollars and thus to reduce inflation. They exported deflation, as it were. After China joined the World Trade Organisation in 2001, globalisation went into overdrive and China became the deflation engine of the world. Everything was now for sale at a tenth of the price through Alibaba.
Perfect inflation storm
Looking ahead, inflation is again the main risk for the economy and the stock market. A perfect inflation storm is brewing, in which structural factors such as an ageing population, regionalisation, the increased market power of companies, the tight labour market, the ever-growing government and the expensive energy transition are combined with irresponsible monetary and fiscal policies.
As if that were not enough, after a capacity-consuming corona crisis, we are suddenly faced with a war that is causing a major shock in energy and food prices. More demand than supply, resulting in higher prices. It is striking to what extent wages can now rise. Actually, the only inflation measure that matters is unit wage growth or the employment cost index (next publication on 29 July). After all, much of inflation is noise as a result of the corona crisis and the Ukrainian war, but ultimately it is the development of wages that matters in connection with the much-feared wage-price spiral.
Since the 1987 crash, investors have learned not to go against the central bank. Whenever stock markets came under pressure, the Fed came to the rescue and helped limit the damage. For the first time since 1987, this is no longer possible. The Fed has to fight inflation and has so far shown that it too is not infallible. As in the 1970s, inflation has been labelled temporary, something that Powell will no longer go around saying, but which is still the FOMC’s forecast. In technical jargon, the Fed is then running behind the inflation curve, whereas the aim is to run ahead of it. Unfortunately, it will be some time before that curve comes into view. Until it does, the bond market will remain unstable and rising interest rates will put pressure on the equity market. The wait is for the Fed to really panic, only then can the market stop panicking.
Sub-optimal outcome
The Fed bases its policy on the output gap and the Phillips curve, but inflation is a complex and intricate phenomenon, especially in the current complex inflation storm. The probability of a sub-optimal outcome is high and that will not reassure financial markets. A popular index in the 1970s was the Misery index, which simply added up inflation and the unemployment rate. If the Fed thinks it can fight inflation by slowing the economy, it must realise that inflation can remain high while unemployment rises.
The real problem for investors is that equity and bond markets have not appreciated on the basis of higher interest rates. Because the Fed has supported financial markets directly or indirectly for many years, excesses have built up that take a long time to clear. In the 1960s, financial markets initially ignored rising inflation and even rising interest rates. At some point, the stock market corrected as a result of rising interest rates, but even then, interest rates continued to rise. Before share prices can rise again in a sustainable way, interest rates must come down, and that takes time.
But even this adjustment process does not take place in a straight line. At some point, it is likely that central banks will want to reassure the markets. For example, the ECB is in the game differently than the Federal Reserve. For the Fed, there is no doubt that the dollar will remain the currency of the United States for years to come; the ECB must first and foremost defend the euro. The interest rate differentials between Italy and Germany are starting to widen. In 2012, Draghi did everything he could to keep Italy in the euro, but now in his role of Italy’s Prime Minister, he will probably see that it is not enough. With the end of the euro and the European Union, Putin will get his way after all. The Fed does not need to guard its currency, but it does value financial stability. Only when this central bank panics can the dollar rise sharply one more time, after which we move into a new phase in which equity markets rise again because interest rates fall.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. His contributions to Investment Officer Luxembourg appear on Thursdays. This column originally appeared on InvestmentOfficer.nl.