Central banks around the world are beginning to tighten their monetary policy in preparation for a return to normal market conditions, but the inflation needed for that to happen is yet to materialise – leaving markets in a state of bewilderment.
A year ago central banks in multiple western countries were looking to use “extraordinary” and previously unheard of policy measures to combat falling prices and weak growth, but this trend has seen a reversal in the past year, according to Robin Anderson, a senior economist with Principal Global Investors.
“Fast forward one year, long-dated government bond yields have picked up from ultra-low to low. Central banks are not pushing the boundaries of monetary policy out further. In general, they are moving back inside the lines,” she said.
However, while central banks are moving back toward normalcy, Ms Anderson cautioned that they may have “declared victory too early”, noting that inflation is not “co-operating” despite the improved economic growth.
“Inflation reports have generally surprised to the downside this spring and summer. More broadly, core inflation remains below bank targets in many regions,” she said.
“Market valuations are getting lofty but underlying inflation could be signalling something about weak demand, which if ignored, could lead to policy error.”
The reason this divergence between inflation and economic strength is so confusing is that it results in different asset markets signalling different potential outcomes, explained David Sokulsky, Crestone Wealth Management’s chief investment officer.
Division between inflation and economic growth has resulted in equity markets positioning themselves for an optimistic future, all the while bond markets prepare for a bleaker economic future, Mr Sokulsky said.
“It’s unlikely that both equities and fixed income markets can both be correct,” he said.
“If the outlook proves optimistic, fixed income will prove to be mispriced; conversely, if inflation and growth disappoint, equities will prove to be pricing in an overly optimistic future.”
As a result, Mr Sokulsky said investors should “take a more prudent approach to investing”, but that this doesn’t mean avoiding markets or risk.
“We expect the investment environment will be more challenging this financial year compared to last, and in this scenario the best approach is to employ a globally diversified investment strategy which is conservatively positioned,” he said.
“Moderating risk and being prudent will become more important than it has been for some time.”
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