The unexpectedly high inflation rates draw even wider circles. In the meantime, many classes of securities are showing significant price losses. The question is whether the negative environment is already being reflected by market prices.
The innermost circle symbolizes the massive loss of purchasing power triggered by high inflation. In Europe in particular, high energy prices may have already triggered a recession. Numerous economic indicators have been falling for months. At the global level, the levels of the indicators still point to growth, albeit at a low level. However, the falling trend (momentum) is worrying.
Key interest rate hikes
The next circle represents the rapid and broad-based rate hikes to restrictive levels. The rapid and synchronous rate hikes are already putting pressure on the financial system and the economy. However, more and more central banks are signaling beyond this that they want to raise their respective key interest rates to restrictive levels. In addition, the US central bank is making it clear that it intends to keep key interest rates at a higher level “for some time.” The higher consumer and producer prices and the tightening of the monetary policy environment mean a higher cost burden for companies and consumers. Added to this is the strong strengthening of the US dollar this year, which has made servicing debt in US dollars more expensive.
Tightening of the financial environment
In the third circle, there is a tightening of the financial environment. Many securities markets are showing price losses due to the significant increase in expectations for future key interest rates. The higher interest rates reduce the current value of future cash flows (the present value). In addition, higher interest rates are weighing on the most interest-rate-sensitive segment of the economy: the real estate market.
The fourth circle describes liquidity strains. The latter has been added as a driving factor. The sharp decline in asset prices leads to losses for asset holders. To compensate for the losses, market participants may be forced to sell (liquidate) some assets to create liquidity. This process is amplified when assets with price losses are leveraged. Last week, margin calls (higher cash as collateral for price losses) led to strong selling pressure on UK government bonds as UK pension funds faced large price losses due to interest rate increases. In line with this, indicators of future market fluctuations (the volatility indicators) have risen significantly for bonds, exchange rates and equities. Some risk indicators are already above 2008 levels: The difference (swap spread) between the interest rate at which money is swaped with banks and the credit-safe government bonds (German Bunds) signals stress in the system at just under one percentage point. The long-term average is 0.37 percentage points.
Last but not least, the fifth circle comprises the rising risks of a global recession. The more circles that affect economic activity, the more pronounced the recession would be. Here, the key question for the stock markets is to what extent a recession-related decline in earnings is already priced in. If a global recession does indeed occur, it is by far the best forecast. Working assumption: A pronounced recession is unlikely to be reflected by market prices, while a mild one is.
Too pessimistic and falling inflation
On the positive side, two factors stand out. First, reporting is already very negative. This is an indication that an exaggeration of sentiment could take place on the negative side. This would mean that numerous asset classes would already be cheap now or soon. Second, significantly falling monthly inflation rates would make it easier for central banks to cut key interest rates. This could even trigger a mini-boom in many asset markets.
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Prognoses are no reliable indicator for future performance.