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Everyone is now aware of the US Federal Reserve’s switch to a more restrictive monetary policy. The Bank of England continues to tighten its stance, with a further 0.25% hike in its key interest rate. Close to half the members of its Monetary Policy Committee voted in favour of a rate rise of double this magnitude (+0.50%), implying that the pace of its normalisation was behind the curve.
The European Central Bank (ECB) had remained noticeably more accommodative, and little was expected from its last meeting. However, as is often the case when little is expected from a central bank meeting, there is much to say. Whereas the initial policy statement held few surprises, the Q&A session was much more hawkish in tone than expected. Whilst confirming that the main scenario remains one of inflation softening by the end of the year, Christine Lagarde abandoned the term “transitory” and emphasised the heightened risks for inflation, which could remain higher than expected in the short term and through to year-end. The ECB President also insisted on the strength of the labour market in the eurozone and commented that she did not consider the recent hike in risk premiums on bonds to be very significant. Ultimately, she postponed decisions on many issues to the March meeting, when we are likely to see a good deal of announcements, and stuck to her statement that it is highly unlikely that we will see a rate rise this year.
So, although there were few new announcements, the change of tone is notable. This can be interpreted as a desire to prepare the ground for less accommodative monetary policy in the future. Markets were taken by surprise and fell in the wake of this meeting. And yet there is nothing intrinsically negative about this shift to a more restrictive stance. It would have been far more worrying had the ECB persisted with overly complacent statements denying the reality of inflationary pressure. This applies to all central banks. We must bear in mind that the aim of the extremely accommodative policies in place over the last ten years – with a short break in 2018 – was not just to support the economy and ensure that the financial system and markets functioned properly, but also to stimulate inflation. As inflation has returned in the aftermath of the COVID-19 pandemic, exacerbated by the strong growth environment, it is perfectly logical for central banks to revert to their basic role of ensuring price stability and acting to avert runaway inflation.
Investors must now adapt the way they perceive the economy and markets. Watching the share prices of unprofitable companies soar on speculation fuelled by excess liquidity of high earnings at some point in the distant future is most likely a thing of the past, at least for a while. It will no longer be the norm to count on multiple expansion as the sole rationale for stock market rises. The same goes for risk premiums on bonds that have evaporated without any notable improvement in credit ratings. This does not necessarily mean that a bleak equity market scenario is inevitable or that growth stocks should be abandoned completely. We saw this clearly last week: the strong performances of Alphabet and Amazon on the back of excellent earnings reports are proof that – even in this less favourable monetary environment – there is every reason to believe that share prices will follow the pace of corporate earnings growth. The end of “cheap money” does not mean the end of performance.
Written on 4 February 22 by Olivier de Berranger, CIO, LFDE