FFinancial repression and fiscal dominance – much has been written about these two correlated manifestations of the new monetary policy regime in Euroland in recent years. In a nutshell, financial repression means that central banks artificially keep nominal interest rates below the rate of economic growth, so that states can theoretically (relatively) easily grow out of their debt. However, the implemented real interest rate trap also initiates a gradual redistribution from savers to debtors. With the twin, fiscal dominance, monetary and fiscal policy have swapped their traditional roles: central banks ensure solvency, while governments “manage” inflation.
The summoned spirits of Goethe’s sorcerer’s apprentice are currently showing up – and you won’t get rid of them that quickly. After the euro inflation rate overshot the ECB’s target due to several years of monetary sleeplessness, there is an interesting visual lesson in the “cooperative financial executive”. Realpolitik is discussing almost every day how the rise in prices can be stopped – inflation peaks, concerted actions and market interventions are being proclaimed. And the currency watchdogs are staring in particular at fragmentation and spreads, i.e. the yield differences on government bonds within the currency group. Possible interest rate burdens for individual European finance ministers seem to concern the central bankers more than inflation rates at country level, sometimes in the double digits. The universal monetary policy mandate – price stability – is obviously taking a backseat to the political goal – ensuring the cohesion of the eurozone. However, the latter is undoubtedly the sole task of democratically legitimized governments. Wrong world!
What is also economically grotesque about it: interventions in the price mechanism rarely have a lasting effect. They undermine allocation and scarcity signals. They thus hinder the necessary and natural adjustment processes in a (social) market economy on the supply and demand side. And when it comes to monetary policy, there are Babylonian confusions: Monetary tightening combined with spread control leads to a policy of “hü and hott”. The result: Foreseeably too few rate hikes by the ECB, with a view to combating inflation, is like throwing cotton balls. The real key interest rates will remain clearly negative and therefore not have a restrictive effect. “You had one job!” It says in the movie “Ocean’s Eleven”. Incidentally, there is experience from the 1970s – do you really have to repeat all the mistakes made back then?
Recognizing the signals of an impending reversal
Conversely, for investors, this means that inflation rates and inflation expectations will remain higher than they have been for decades. The old Bundesbank wisdom – “Anyone who flirts with inflation will be married by it” – has (unfortunately) come true. Four (percent) seems the new two. Protection against inflation when investing is therefore essential. This is particularly true because many people are subject to the nominal illusion, i.e. they focus their considerations on the nominal and not the real return. With four percent inflation, a euro loses half of its value after just over 17 years. “Inflation is a pickpocket,” as a former German labor minister once said.
With a view to the important preservation of purchasing power, equities were, are and will remain the broadest and most easily investable investment segment in the long term. This is because they offer an inherent protection against inflation to a certain extent, namely to the extent that companies can pass on higher costs in the form of price increases. However, the stock market outlook is currently clouded by a recession that is likely to occur in the course of 2023.
However, a look into the past can help to roughly estimate bottoming out. In recent decades it has been observed regularly that the calendar years before a recession were bad years for stocks: the financial markets anticipated the phase of economic weakness. On the other hand, calendar years with strongly negative economic growth rates were usually quite good stock market years. Because the financial markets usually anticipated the future economic recovery in the first phase of the downturn.
In concrete terms, it is therefore important for investors to recognize the signals of an imminent reversal from the current stock market pessimism to optimism. The most important sign of this should be a cycle of rate hikes in the USA that is drawing to a close. This could be the case in spring 2023. Then inverted yield curves should also indicate the upcoming significant economic slowdown. Further indications would be leading indicators that have fallen to recession levels, such as purchasing manager indices, as well as price-to-book ratios on the stock market towards one on the valuation side. The latter are less volatile than the more popular price gain views and involve a kind of intrinsic value hypothesis.
The author is CIO Multi Asset Europe at Allianz Global Investors.