Clear and Present Danger
Updated: May 16, 2022
At the time of writing, global equities are up around 17% in US dollars year to date. Sterling weakness has added a further 3 percentage points or so for UK-based investors. What are equities’ prospects for 2022?
"If you are heavily invested in equities, it is probably time to start scaling back"
This time last year I wrote that, “yield curves – long-term interest rates minus short-term interest rates – are positive again across much of the world. Against such a backdrop, equities should remain well supported.”
Predicting what ‘risky’ assets such as equities are going to do on a one-year basis is always a bit of a lottery, but over the decades the yield curve has proven to be one of the better predictors.
Short-interest rates are determined by central bank policy, while longer-term interest rates – bond yields – are more market- driven and reflect longer-term economic growth prospects.
The business or economic cycle, at least in theory, includes a period of expansion followed by a contraction or slowdown, with one full cycle lasting a few years. In practice, things are not so neat.
Since rising bond yields are a sign of improving growth prospects, they may eventually signal economic overheating. Central banks do not like economic overheating, as it tends to mean inflation rising above the optimal level, generally 2%. To combat such inflation, central banks increase short-term interest rates to make saving more attractive than spending and thus slow economic growth.
While initial short-term interest rate increases may not have much impact on economic activity, further increases will see growth and thus inflation expectations fall. This will be reflected in falling bond yields i.e.. a falling yield curve.
Eventually, economic activity declines to the point at which central banks become comfortable with the inflation outlook, allowing them to cut short-term interest rates. Saving becomes less attractive than spending, economic growth expectations pick up, bond yields start to rise again, and a new cycle begins.
A negative yield curve – high central bank policy rates - is bad for equities for two reasons. First, it means economic activity, and so corporate profits, will fall. Second, high short-term interest rates mean equities become relatively less attractive on a yield basis. A positive yield curve works in the opposite way. At least in theory.
In practice, however, one can never discount the possibility of a shock that, by definition, could not have been anticipated and thus not discounted by the yield curve – Covid-19 is a good example of such a shock.
However, while such shocks may render single predictions to be significantly wide of the mark, they do not in general cause the yield curve to lose its predictive power. Indeed, they are often great opportunities to enhance investment returns, causing as they do equities to fall sharply, and thereby presenting great buying opportunities.
However, what may now be presenting a clear and present danger to the power of the yield curve is the sharp rise in inflation the world has witnessed during recent months. Between the mid-’60s and late-’70s, high inflation became entrenched, i.e. more structural than cyclical. The effective loss of the cyclical signal played havoc with the yield curve and its predictive power. Indeed, equities fell in real terms over the 15 years and did not fully recover their losses until well into the ’80s.
While bond yields have risen from their lows of last year, they have not risen to the extent that high inflation is expected to become entrenched – indeed, they have fallen slightly over the past four months during which inflation has continued to rise.
Significantly, the US Federal Reserve recently announced it no longer believed rising inflation would be ‘transitory’, which could be interpreted to mean that monetary tightening would be brought forward.
Is it possible that we can return to ’70s style ‘stagflation’ – the toxic combination of low growth and high inflation? I think it is unlikely but cannot be ruled out. Ultra-loose monetary policy in the aftermath of the 2008-9 economic crisis did not lead to high inflation as many feared.
In the face of economic weakness over the past couple of years, many governments turned the fiscal taps on, apparently unconcerned about inflation risk. It is believed the high inflation of the late ’60s and ’70s was rooted in very loose monetary and fiscal policy in the early ’60s, somewhat like what we have today.
Regardless of whether inflation falls back to tolerable levels, I think the prospects for equities over the next 12 months are worse than they were this time last year. The reason? Central banks are likely to raise interest rates in 2022, which means – yes, you guessed it – a flattening yield curve. If you are heavily invested in equities, it is probably time to start scaling back.
Published in What Investment
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.