Investors, Inflation and Interest Rates – What’s Next for the Markets?

Autor: Maria Paun
3 min

With the banking crisis in the U.S. in March, some already saw a new global financial crisis approaching the market. Since then, however, the broad market has performed well.

The most important factor in the market’s resilience has been that both the Fed and the U.S. Treasury have responded very quickly to the unfolding crisis.

The measures taken have so far proven sufficient to stabilise confidence in the U.S. banking system.

Although the troubled banks were by no means small, they were seen as regional players that had clearly made mistakes in risk management.

There are several arguments for the generally positive sentiment this year.

The most important reason is that inflation rates started to fall, which should eventually lead to an end of the monetary tightening cycle.

The Fed recently paused after raising rates ten times in a row, but expects a few more hikes this year. Other major central banks, such as the ECB and the Bank of England, are still in the process of raising interest rates

We are not out of the woods yet, and there is a risk that inflation will continue to rise and central bank tightening measures will last longer than expected. But overall, the most likely scenario is that inflation peaked last year and we are approaching a level where central banks do not need to tighten further.

The level of interest rates set by central banks affects yields on risk-free government bonds, which in turn correlate negatively with valuations of risky assets such as equities.

In simplified terms, this means: If interest rates rise, the valuation level on the stock market tends to fall – stocks and their prices fall.

The negative development of the stock markets last year was almost exclusively explained by the compression of multiples such as the P/E ratio (=share price divided by earnings per share).

Investors demanded higher earnings yields given the higher yields that safe bonds offered. This year, the opposite is true. With market participants already pricing in lower interest rates in the future, equity valuations have risen, even in a mediocre earnings environment.

It is also worth noting the low volatility in equity markets. The VIX index, which measures the implied volatility of the S&P 500 index, has fallen to its lowest level since the pandemic.

Low volatility not only boosts stock market investor confidence, but also leads to buying by systematic investors, which brings additional demand to the market.

Recession fears have been a constant feature of market activity since the onset of Russian aggression, which brought an increase in energy prices and exacerbated the already existing inflation problem.

The yield curve in the U.S.A. – an indicator that has predicted recessions with a high degree of accuracy in the past – has been inverted sharply for some time, which underlines the justification for the fears of recession.

Despite some red flashing recession indicators, the U.S. and Europe have so far managed to avoid a hard landing (= hard recession).

Even though most economists agree on the high probability of a recession, there is heated debate about both the timing and the extent of a future economic downturn.

The significant turnaround in oil and gas prices since last summer has increased the odds of a so-called soft landing, a scenario that ranges from a mild recession to a slowdown in GDP growth.

As the expected onset of a recession has been postponed further and further, investors have been able to regain some composure, and financial market volatility has declined.

Currently, markets are pricing in a combination of a soft landing and a resulting less restrictive Fed going forward.

In the event of a significant economic slump, central banks would adopt a decidedly dovish stance, but in such a case the positive effects of a multiple expansion would probably be overshadowed by the negative effects of falling earnings expectations.

Ironically, the greatest threat to current stock prices probably comes from an economy that surprises significantly to the upside. Currently, the S&P 500 is trading at 20 times expected earnings, above both its 5- and 10-year averages. At the same time, U.S. real yields are trading at their highest levels since 2010.

This combination is unsustainable, and in the end, one of the two will have to give way. Too strong an economy will force the Fed to raise rates further, and current valuations are simply too high for that.

From now on, the main driver will be the evolution of inflation and, as a byproduct, the level of interest rates set by major central banks.

Risk assets will find support if the trend toward falling inflation and less aggressive monetary policy prevails and if the major economies manage to avoid a severe recession.

Another thing to watch is whether the current hype around artificial intelligence continues. The proof will have to come in the form of improved earnings prospects for the companies affected by this trend.

On the other hand, market breadth has been fairly narrow this year as the rally has been driven by the incredible performance of a few large-cap stocks.

For a new bull market to be sustainable, a larger number of stocks must participate in the uptrend.