The 1973-74 bear market was a brutal one as investors fretted about rising inflation and faltering economic activity, which was exacerbated by OPEC’s decision in October 1973 to stop exporting oil to the United States.
Moving in lockstep
The US blue-chip sharemarket index, the S&P500, tumbled 42.6 per cent in the 21 months ending in September 1974.
Fast-forward almost half a century, and investors are again spooked by rising inflation and sputtering economic activity.
La s&P500 index suffered a bruising 20.6 per cent decline in the first six months of 2022, its worst first-half performance in more than 50 years.
Since then, however, financial markets have rallied strongly, with the prices of stocks, bonds and cryptocurrencies recording impressive gains.
Since hitting a low on June 16, the S&P500 has risen by 12.6 per cent, while the tech-heavy Nasdaq has climbed 16.4 per cent.
The only plausible explanation for this rally is that – like Corrigan – investors have formed the view that it’s time to go get back into the market because things can’t get any worse than they already are.
And this implies that investors are expecting global inflationary pressures will quickly buckle under the barrage of interest rate rises already unleashed by the world’s major central banks.
After all, the central banks in developed countries – such as the US Federal Reserve, the Bank of Canada, the Reserve Bank of Australia, the European Central Bank and the Bank of England – are now moving in lockstep as they lift interest rates to tackle rampant price rises.
This synchronized and historically unprecedented monetary tightening will undoubtedly reduce global demand, which will take a lot of heat out of inflation.
Indeed, there’s a major risk that these synchronized rate rises will cause economic activity to contract too sharply, plunging the global economy into recession.
Already, investors are becoming optimistic that the US central bank – which has been raising rates at the fastest clip since former Fed chair Paul Volcker conquered double-digit inflation in the early 1980s – is nearing the end of its tightening cycle.
Signs efforts are working
The Fed raised its interest rate target by 75 basis points last week, bringing its official interest rate to a new range of between 2.25 per cent and 2.5 per cent. At the beginning of the year, the Fed’s policy rate was close to zero.
Although it will take time for the full effect of these rapid rate rises to be felt, there are signs that they are already weighing on demand, which will help ease inflation.
The US housing market is deteriorating, consumer spending is falling and retailers are offering hefty discounts to clear surplus stock, which suggests the Fed’s attempts to rein in household spending to slow inflation is working.
Investors are also hopeful that falling commodity prices will reinforce this downward pressure on inflation.
Commodity prices are also coming under pressure, both from the darkening outlook for global growth and from the surge in the US dollar.
Because most commodities are priced in US dollars, a stronger greenback makes them more expensive for non-US buyers, which helps to curb demand and put downward pressure on prices.
Commodity prices soared earlier this year, as production struggled to keep pace with the global economic recovery from the pandemic, and after Russia’s invasion of Ukraine triggered a surge in oil and gas prices.
But prices for oil, metal and agricultural products have fallen sharply since early June, and this should push official inflation figures lower in coming months.
Investors were cheered last week when Fed chairman Jerome Powell acknowledged there were signs that interest rate increases are beginning to bite, and that future rate rises are likely to be smaller.
This was confirmed by the Fed’s downgrade of the state of the US economy. In the statement it released after its June meeting, the Fed said “overall economic activity appears to have picked up”.
The statement released after last week’s meeting noted that “recent indicators of spending and production have softened”.
not so neutral
Still, some analysts believe that investors are premature in betting on a dovish pivot by the Fed.
They point out that US private sector wages and salaries jumped to a record 5.7 per cent in June from a year earlier, which will continue to put upward pressure on prices, particularly in the services sector.
What’s more, they point out that although the US housing market appears to be cooling, rents lag home prices by about a year. As a result, shelter costs, which make up about 40 per cent of the US consumer price index, are likely to keep rising sharply into next year.
Analysts also believe that investors are wrong to take comfort in Powell’s comments that US interest rates are now close to the “neutral” level, where they neither constrain nor spur economic activity.
Investors interpreted Powell’s statement as further confirmation that the Fed is close to the end of its monetary tightening cycle.
But many economists are skeptical that the Fed is anywhere close to reaching a “neutral” level of interest rates.
Former US treasury secretary Larry Summers attacked Powell’s assessment that US official interest rates are close to neutral, saying that it was “analytically indefensible”.
In an interview on Bloomberg Television on Saturday, Summers said: “There is no conceivable way that a 2.5 per cent interest rate, in an inflating economy like this, is anywhere near neutral.”
He added that he was concerned that the Fed was still engaged in “wishful thinking” about how much it will take to bring inflation down from four-decade highs.
The exuberant rally in financial markets over the past six weeks suggests that investors are more than happy to join in the Fed’s “wishful thinking”.