In short, economic reality has caught up with central banks. With rising inflation, they are now facing a very different kind of problem. The solution to this problem requires another strategy than the one they have adopted since the financial crisis, which consisted essentially of reducing interest rates as soon as there was the slightest problem, flooding the markets with liquidity and thus supporting asset prices. After years of central banks’ objectives (fighting the risk of deflation and stimulating growth) being very favorable to financial markets, the situation has fundamentally changed.
History teaches that when the main objectives of central banks, growth and inflation, are in conflict, it is better to exit the financial markets. Today, we are in such a situation and central banks, at least the most important one, have clearly decided that their priority is to fight inflation and that a reduction in growth, or even a further decline in the markets, can even help them achieve this objective. In this respect, it is also important to put the fall in stock markets in 2022 into perspective by comparing it with the rise of recent years. In euro terms, the global equity index remains almost 17% above its pre-pandemic level and more than 60% above its end-2018 level.
The positive scenario for the financial markets would be a rapid decline in inflation and a soft landing for the economy. However, it seems somewhat illusory to count on such a scenario. On the inflation side, a new surge in energy prices is a possibility, while rising food prices will lead to social demands. As far as growth is concerned, soft landings are the exception, rather than the rule.
The main positive longer-term argument for the stock markets and for gold is that the high level of debt in the global economy and the fragility of the financial system will prevent the monetary authorities from going very far in normalizing their monetary policies. They could therefore use a temporary decline in inflation as an opportunity to claim victory and stop monetary tightening, or even to return to expansionary policies. Such a reversal would clearly be favorable for gold. For equities, it will be a matter of being selective. To the extent that inflationary pressures are likely to reappear fairly quickly, it will be a matter of distinguishing between companies whose business model is being undermined by inflation and those that have the qualities necessary to continue to thrive in a more inflationary environment.
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