The recreation is over : fasten your seat belts

Those who follow my various publications know that I have been anticipating a major financial crisis over the past years based on the over indebtedness of Western Governments and the transformation of the monetary policy of central banks into a support of fiscal policy.

Inflationary pressures unpredicted by central banks

Inflation has whistled the end of years of easy money and fiscal indiscipline. The control of inflation is the core responsibility of central banks who did everything to boost it in vain. Now, it comes back with a revenge in an uncontrolled fashion to reach 6.8% in twelve months. The monthly numbers have shown, at the latest in June 2021, it became clear that something unusual was happening.

It is the undisclosed reason why the Federal Reserve started to taper its purchases of financial assets. The recent accelerations announced by President Jerome Powell is welcome. The last thing the economy needs is a monetary policy that aims at stimulating the inflation to reach 2%. Ever sensitive to market reactions (whether it is legitimate or not), the Fed decided to do it gradually.

On the front of interest rates, the decrease motivated by the pandemic that boosted stock prices is no longer applicable. The announcement of three increases in 2023 contrasts with the statement that no increase was to be expected before 2024. The decrease of short term rates crashed the 10 year Treasuries close to zero. Today, those rates oscillate around 1.50% offering the Fed a boulevard to increase short term rates. An economic impact on the economic recovery is therefore unlikely to be severe.

Asset inflation provoked by central banks

However the bubble of asset inflation created by the massive injection of liquidity in the economy is very likely to be severe. The current price earnings ratio of the Standard and Poor’s 500 index currently is 29.41 times. i.e. twice the historical average.

Contrary to the predictions for a forward P/E around 22 times in 2020 proved wrong, providing the stage of a major correction. According to the Financial Times, when the S&P 500 clinched its first record closing high in three weeks and extended its year-to-date gain to 25 per cent, more than 210 stocks in the index were at least 10 per cent below their 52-week highs. Apple, Microsoft, Nvidia, Tesla and Google parent Alphabet — have accounted for more than half of the S&P 500’s returns since April.

A combination of inflationary pressures that might, at least partly, impact the profitability of companies or the purchasing power of citizens (or both), and higher interest rates, will reduce the profitability of companies.

It is time to offload overpriced assets: fasten your seat belts. Turbulence ahead will be strong and often unpredictable. The tsunami season has started.

The international picture is diverging

The European Central Bank has clearly minimized the risks of inflation. At the end of November, it President was reassuring. The European Central Bank (ECB) must not rush to tighten its monetary policy since the elevated inflation rates look transitory, the bank’s President, Christine Lagarde, told the Frankfurt European Banking Congress.

Inflation across the Eurozone surged to a fresh record high in November with more than half of the increase connected to the surge in energy prices. Figures from the EU’s statistics office Eurostat yesterday show inflation in the 19 countries sharing the euro rose to 4.9%, a year-on-year surge in line with an earlier Eurostat estimate.

The European Central Bank, watching the resolute action of the Fed, cut its bond purchases on December 16 but vowed to continue its unprecedented monetary policy support for the euro zone economy into 2022. The ECB left its benchmark refinancing rate unchanged at 0%, while the rate on its marginal lending facility remained at 0.25% and the rate on its deposit facility was kept at -0.5%

The Bank of Japan announced on December 17 that it would wrap up its corporate bond and commercial paper purchases, which increased the balance of its holdings by ¥20tn ($176bn), by the March 2022 deadline as scheduled. But it will continue pumping tens of billions of dollars into the economy in hopes of eventually attaining its elusive 2% inflation target and getting the economy to grow faster. The inflation in Japan is still nil.

CEO at Galileo Global Advisors and Adjunct professor Columbia Law School.