The trend is somewhat fragile, as disinflation continues to depend on traditionally volatile commodity prices, but the fall in inflation expectations among households and businesses is conditioned by a firmer base. That said, the trend cannot be taken for granted as long as wage momentum remains strong in the current persistently upbeat economic environment.
In this context, it is striking that the Fed and the ECB encourage investors to wait for further rate hikes. The credibility of central banks has suffered, so they are forced to insist on their policy to try to regain the respect of the market and investors. History also teaches that premature easing during a period of runaway disinflation can force central banks to go even further if they then have to put up with their policy.
Wage increases of 4-5% in the US and Europe correspond to 3-4% inflation, not the 2% target. The current slowdown in inflation will likely weigh on wage increases soon, but not as much as needed.
Paradoxically, the US banking crisis stimulated liquidity, as commercial banks queued up at the Federal Reserve’s emergency discount windows. But now that the debt ceiling has been raised, the US Treasury will have to replenish its coffers by borrowing hundreds of billions of dollars from the Fed. This will drain the reserves of commercial banks and could further trigger weakness in the risk assets.
Money market funds, investment grade bonds and the S&P 500 all returned the same in mid-June, as if risk premia had taken a backseat. “All three had the same yield in mid-June, rather as if risk premiums had taken a backseat,” the Edmond de Rothschild AM team explains.
“Basically, the arguments in favor of overweighting equities today – when there is still a risk of recession – have to be based on the expectation that a growth ‘shock’ is coming,” he says. One could, for example, view the artificial intelligence revolution as a ‘shock’ (even if the stocks directly affected by AI are already very expensive). “In this scenario, artificial intelligence is a force capable of generating enormous productivity gains in all economic sectors,” as these experts comment.
Since Robert Solow’s famous aphorism: “The computer age is seen everywhere except in productivity statistics”, new technologies do not usually generate the expected productivity increases. According to economist Robert Gordon, the Internet revolution did indeed improve American productivity in the decade it declined between 1995 and 2005, but only during that period. For the rest, the lack of productivity growth in the other developed countries is, to say the least, disconcerting.
“Of course, it could be different in the case of artificial intelligence, but the previous episodes justify a minimum of caution,” these analysts describe. Companies like Nvidia have reached their price on Wall Street more than 270%. Hence, many investors question whether this return/risk binomial should turn more towards the bond market with desirable returns in historical terms.
“In the shorter term we will have to face headwinds such as efforts by central banks to cool the economy, an imminent crunch in liquidity and the decline in greed inflation… As a result, our portfolios are only slightly underweight (and not overweight) in equities”, they comment from EdrAM. As for bonds, the fact that central banks can support beyond current market expectations is not yet of concern for duration.
In fact, the middle and long ends of the yield curve could result from central banks’ determination to beat inflation as a way to cut interest rates later. And hopes can only rise if disinflation continues in the coming months. “This is the reason why we are overweight in fixed income, favoring investment grade bonds, as well as good quality ‘high yield’ bonds (BB for example)”, specify the experts of the French manager.
Whether we are more confident of disinflation than of a new era where artificial intelligence drives productivity and we prefer fixed income to equities is simply based on the current environment. “The risk of recession and reduced liquidity from excessive central bank tightening remains, which could dwarf the longer-term outlook based on game-changing developments,” he concludes.
