The barrage of ultra-low interest rates and asset buying (aka quantitative easing) peaked a short while ago and has started to turn as western central banks begin to react to the high inflation data. This is important as ultra-low interest rates encouraged investors to move cash (which has been making negative returns when adjusted for inflation) to riskier assets such as corporate bonds and equities in order to generate acceptable returns. Central banks further encouraged this dynamic by conjuring huge amounts of money out of thin air and buying assets which they then held on their balance sheets.
This promoted a narrative by some investors that ‘there is no alternative’ (often abbreviated to TINA) to equities given the artificially depressed returns available elsewhere in the market. However, TINA is facing redundancy as government bond yields rise and central bank mandated asset buying schemes are halted and/or reversed.
Despite the economic shock of the Russian invasion of Ukraine, central banks are continuing to flag a likely acceleration in interest rates rises as inflationary pressures continue to exceed expectations. After adjusting for inflation, interest rates remain negative which central banks judge to be too slack given strong labour markets.
It is uncomfortable that this is happening at a time when equity prices remain elevated. At the end of March 2022, the MSCI World Net Total Return Index was just 3.3% below its highest ever level which was recorded earlier this year (4th January), in Sterling terms. The index has returned more than 70% over the past five years which means investors are sitting on a lot of profit which they may start to bank given a challenging outlook for earnings.
The Office of Budget Responsibility (OBR) has stated that it believes UK real household income will see the sharpest contraction since records began in the 1950s. This dynamic is not confined to the UK.
The events in Ukraine are amplifying these trends as global energy and food prices respond to the risks of reduced supply. We do not believe the sanctions on the Russian economy will be rescinded on a ceasefire. Volatility in commodity prices and uncertain supply chains leads to companies holding more stock, which is a drag on cash generation.
On the positive side, China has considerable scope to stimulate its economy and manage its ailing property sector. Banks in the west have strong balance sheets, which has seldom been the case at this point in the cycle.
Perversely, another reason not to be too fearful about the future direction of markets is that a recession narrative is likely to build over the coming months and inflation is likely to peak and start coming down. As a result, interest rate expectations are likely to fall. This means that central banks may well capitulate earlier than expected. In other words, the rising interest rate cycle in the west may be considerably shorter than many fear and if this came about it would be a positive surprise.