The writer is a financial journalist and author of “More: The 10,000-Year Rise of the World Economy”
For years, asset markets have been behaving rather like the crew of Star Trek: on a mission “to boldly go where no man had gone before”, reaching new highs and finding new vehicles for speculation.
But 2022 was a reminder that, like the cast of the sci-fi series, missions can have casualties. In this case, the “redshirts” — the hapless extras sent down to face the danger with Captain Kirk and Mr Spock, only to be slaughtered by that episode’s monster — were the cryptocurrencies, which suffered a meltdown culminating in the collapse of FTX.
But more conventional assets had their problems too; the S&P 500 index is down 16 per cent at the time of writing and the MSCI Emerging Markets index has dropped 23 per cent.
The reasons for these setbacks are well-known and interlinked. The first was Russia’s invasion of Ukraine, which disrupted energy markets and added a “supply shock” to existing inflationary pressures. This aggravated a second factor: the struggles of central banks to set the right monetary policy in the face of a combination of rising prices and a hit to consumer demand. Financial markets have spent the year debating whether central banks would either do little to restrain inflation or do so much that they would crash the economy.
Not far below the surface of this debate was a more pressing long-term question. Given the level of debt built up across the developed economy, is there a limit to the extent of monetary tightening? Ever since the financial crisis of 2007-09, attempts to return interest rates to what have been regarded as “normal” levels in the late 20th century have been cut short by market wobbles. As Scotty regularly used to say of the engine of Star Trek’s USS Enterprise, “She cannae take it, Captain.”
As a result, fears for the fragility of the financial system are the best source of hope for the bulls. That is why markets have been desperate for any sign of a “pivot” by the Fed. That pivot need not involve a decision by the Fed to cut rates; simply a sign that the pace of rate increases has slowed. At the moment of maximum danger, the markets will be rescued just as Messrs Kirk, Spock and McCoy would be “beamed up” to their ship in the face of a Klingon attack.
So there was a lot of optimism this week when the Federal Reserve held its latest rate-setting meeting. After all, inflation had dropped in November to 7.1 per cent, its lowest rate this year. And the Fed did slow the pace of rate increases, unveiling a half-point jump rather than its previous shifts of three-quarters of a point. But Jay Powell, the Fed chair, was not ready to rescue the markets just yet. The central bank needed to see “substantially more evidence” that inflation was abating before easing up on the monetary brakes. The Fed’s projections were for higher rates, higher inflation and slower growth than its previous forecasts.
Perhaps investors’ desperate need for reassurance from the Fed ought to be a cause for reflection. In a normal cycle, interest rates should rise as the economy booms, but equity markets can still prosper because profit forecasts are being revised higher.
Since the financial crisis of 2007-09, there has been a less healthy combination. Economic growth has been disappointing in the developed world but that hasn’t held back risky assets; equities, high-yield debt and property have all flourished. Is this really healthy? Ultra-low short-term interest rates may have made it a lot easier for the corporate sector to finance itself but may have led to the survival of too many “zombie companies” and thus prevented the “creative destruction” needed to transform the economy and boost productivity.
A world in which economies stagnate while financial markets boom would have struck Mr Spock as highly illogical. But it is quite possible that 2023 will see that pattern resume. All the markets want for Christmas is the hope of lower rates; a stronger economy is not really required.
For things to change, one of three things would need to happen. The first would be for inflation to become entrenched in developed economies, as it did in the 1970s. This is not out of the question; a combination of an ageing population and a crackdown on immigration might lead to a wage-price spiral. In turn, that would eat into corporate profits and thus stock market valuations. The second possibility would be a combination of high energy costs and monetary tightening driving down the markets as well as the economy. Again, this could happen; it happened in the early 1980s.
The third possibility would be much more healthy. Somehow, developed economies might find the productivity improvements that could deliver faster economic growth and a higher standard of living for everyone; such a combination should be good for asset markets as well. Sadly, in the absence of some fantastic technological breakthrough, this seems the least likely outcome of the three. In an ideal world, both the markets and the global economy could, in Spock’s phrase, “live long and prosper”. But all too often in the real world, it is only those in the financial markets that do the prospering.