By Ricardo Evangelista
We are living through a phase of divergence between the interests of the real economy and those of investors in the financial markets. What is good for Wall Street is bad for main street, and vice versa. This dissociation between our everyday lives and those of high-flying investors is bad for the reputation of the markets, exacerbating the resentment of those who believe that a global elite is taking everyone else for a ride.
Such views are harsh. Financial markets play a positive role in the economy. For example, they allow companies to raise funds by issuing shares, while also providing a credible venue for the negotiation of essential commodities transactions, such as oil or wheat.
What the markets are now experiencing is the hangover of a decade of growth, which came on the back of a gargantuan monetary stimulus. In the aftermath of the financial crisis of 2008, interest rates remained low, and liquidity - fresh off the money printers - kept being injected into the system. Then the COVID-19 pandemic hit, and this dynamic intensified. Eventually, towards the end of 2021, inflation started to appear on the radar of monetary policymakers and the party came to an end. Interest rates rose and asset purchases stopped.
The global monetary authorities are now on a mission to control inflation, and several senior officials have admitted to being ready to sacrifice economic growth and jobs. The result has been a drop in risk appetite among traders, with the S&P500, the main US stock market index, dropping almost 25 percent relative to its all-time maximum reached in January 2022.
There is a perverse angle to this story. Traders find themselves wishing for bad news in the real economy. They long for the higher unemployment and slower growth that will bring inflation down. Because that is when the Federal Reserve will stop hiking interest rates.
Traders and investors are not evil. They just do not want to see the value of their portfolios drop, which is what happens when the Fed withdraws stimulus, driving flows away from risky assets such as stocks and into to refuge assets, such as cash and gold. This is precisely what has been happening recently, and is likely to continue well into 2023.
To put it crudely. Central banks are trying to bring inflation down by breaking the economy. It is ironic that what is forcing the hand of policymakers is the vitality of the economy. In several countries such as Germany, Japan, France, Canada and others, the unemployment rate has never been lower. Unfortunately, such a strong jobs market is supporting high levels of inflation.
By withdrawing stimulus and hiking interest rates, policymakers will ruin this stellar labour market and most probably trigger a recession. But such is the price to pay for ensuring that consumer prices do not continue to rise and eventually lead to an even worse outcome.
This is, of course, a temporary conundrum. Inflation will eventually drop, and growth will resume. When that time comes the interests of the markets will once again be aligned with everyone else’s. The next cycle of growth will come, and the economic expansion will drive a recovery in the markets.
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