Global equities - Every landing faces turbulence

Those of a certain age will remember the original incarnation of the band, The Pet Shop Boys, and their first (and biggest) true hit single, West End Girls. Among some great lyrics in that song is the line “Which do you choose, a hard or soft option?" For most of the last nine months, investors have been asking the same question in relation to global economic growth – hard or soft landing? Of late, this choice was joined by another - and philosophically more difficult to understand option, known as the ‘No Landing’. If this wasn’t difficult enough for central banks to deal with, the ‘shock waves’ going through the banking sectors on both sides of the Atlantic have created an additional layer of hard or soft options when it comes to the fate of certain banks and any collateral damage to the broader financial system and global economy.

Most asset markets got off to a powerful start this year as the scent of ‘immaculate disinflation’ permeated the air, bringing with it the promise of lower interest rates in the back half of the year and a benign backdrop for the deployment of capital. That narrative started to come a cropper, first in the US, as buoyant economic indicators and sticky inflation spurred concerns about a hawkish response from the US Federal Reserve (Fed) trying to keep price growth in check, and second in Europe where the European Central Bank (ECB) stepped up their war of words (and actions) to bring inflation under control. And as a result, bond, interest rate, and foreign exchange markets began pricing in higher terminal rates for this cycle.

The interplay between interest rates and economic growth is a particularly interesting one at this juncture – and one that is creating a conundrum for central banks. Based on academic research, many would believe that the transmission mechanism of higher interest rates to slowing growth typically takes six to nine months from the commencement of a raising cycle. Therefore, spare a thought for central banks (particularly the Fed), which have stood over one of the steepest and fastest increases in rates only to see modest impacts on growth and inflation.

Some of the most dangerous words in investment are “it’s different this time” and while using them as a general catch-all to explain the unusual is fraught with danger, that is not to say that some factors will change from one economic cycle to the next. Obviously, what sets this interest rate cycle apart from the last two (COVID-19 and Global Financial Crisis) is the absence of Quantitative Easing (QE) – although its reversal is an additional headwind to financial conditions this time around. However, expecting the economy to respond ‘as normal’ to interest rates – the last normal cycle was early this century – and the economy is very different to that now. Things never repeat themselves, but they do often rhyme.

Events of the last few weeks in the banking sector may pick at the scars of the 2007-2009 period and cause people to question if a repeat is about to hit our screens. While Silicon Valley Bank’s collapse was clearly the result of a flawed business model that was poorly executed, the sudden flare-up of risk aversion in the global banking sector might be seen as a proximate cause of the demise of Credit Suisse. In and of itself, it should not have been fatal for a systemically important global institution. Recent years have seen an inordinate number of missteps by the Swiss bank, so in a sense, it has crumbled because the street has simply lost faith in it after years of cartoonish mistakes – again, not a systemic issue for the wider industry.

Yet all of this does create a conundrum for central banks. It could be argued that, for the first time in many years, the goals of financial market stability and price stability (fighting inflation) are at opposite ends of the scales. If both the Fed and the ECB continue on their path of hiking rates - in line with the market expectations at the beginning of March - that could eventually be seen as a Trichet-esque policy error of ignoring financial stress by focusing on the single inflationary needle on their policy compass. If they hold, let alone cut, it could well suggest that they don’t believe their own rhetoric on the strength of the banking system.

Financial stability has clearly become a more prominent risk and difficulty for banks will tend to make loans somewhat harder to come by, and therefore will tighten financial conditions - but the magnitude of the recent tightening of conditions can be difficult to quantify.

Of course, what matters most is how conditions evolve moving forward, and it certainly seems reasonable to posit that credit conditions are going to tighten no matter what, which would take the place of a rise in official interest rates for either central bank to achieve their price stability goals. One would think that investor risk aversion could accomplish the same goal, though the enthusiasm with which punters have bought tech stocks and crypto suggests that animal spirits (and thus the potential demand impetus for future inflation) remain all too alive.

Over the coming months, the central bankers in the cockpit may have to deal with course corrections, gusting winds, and more air pockets before the wheels touch down on this landing – please keep your seat belts fastened!