Rough road ahead for markets as inflation battle unwinds

It coils the spring for an asset boom in the second half of the year as the stars align for investor nirvana: a monetary thaw; light at the end of the tunnel in Ukraine; full economic reopening in China after the omicron massacre; and relief that globalisation lives on.

A chastened Xi Jinping will tone down his wolf warrior macro-Leninism because China cannot do without Western investment and chip technology after all. Emerging markets are the place to be after going nowhere for 15 years. They are extremely cheap.

The Federal Reserve’s broad dollar index has rolled over after reaching an all-time high in October. The US dollar is henceforth in a secular downward slide that will accelerate once the Fed does a U-turn and starts to slash rates.

This will alleviate the painful squeeze in the $US14 trillion market for offshore dollar debt, the prime lubricant of global commerce and investment.

But first the central banks must complete their next blunder. Having unleashed an inflation storm because they failed to heed the warning signals from an explosion of the broad M3/M4 money supply – which typically delivers its punch with a lag of one to two years – they are now making the opposite mistake. They are tightening too hard into an enveloping recession after money growth has collapsed.

The result is already evident in America. M3 contracted at an annual rate of 4.9 per cent over the three months to November in nominal terms, according to the Institute of International Monetary Research. It is almost down to zero year-on-year, something that never came close to happening in the 1970s.

The Fed is not looking at this flashing red signal. It has tied its credibility – and the fortunes of the US economy – to two sets of lagging indicators: jobs and core inflation. The Fed’s Jay Powell is not an economist. This is good. He will recognise that an error is being made – late, but not disastrously late – rather than taking the ship down with an academic idée fixe.

The European Central Bank will tarry longer because it is not about monetary policy at the Eurotower: it is a power struggle between the creditor north and the debtor south over the eurozone’s economic machinery. The Bundesbank is back in charge and this is going to be painful for an economic bloc already facing factory closures, with the risk of permanent deindustrialisation the longer Vladimir Putin’s war goes on.

The ECB will keep tightening into the energy storm as it did in 2008 and 2011 until the ground crumbles beneath their feet. Giorgia Meloni’s honeymoon for Italy cannot last. Once the risk spread on Italian 10-year debt breaches 250 basis points, slow contagion will spread to Club Med, the Baltics and overstretched ERM peggers such as Romania. Markets will focus their attention on the ECB’s putative anti-spread tool and conclude that it can be used only in extremis.

The Bundesbank will find reasons to ensure that it is not deployed, demanding instead that Meloni ratify the EU bailout fund, which she refuses to do because the instrument entails enforced austerity if ever used under colonial commissars from Brussels. This will be the political fight of 2023.

France has put off all its problems by subsidising everything – from diesel to condoms – and suppressing every price signal that it does not like.

But this is the year that Emmanuel Macron has to admit that “whatever it takes” is no longer affordable. His valiant attempt to raise the pension age above 62, the sine qua non of French fiscal viability, will set off a late winter of discontent – or a gilets jaunes II in Gallic vernacular.

Putin may spoil the recovery in the second half by adding an oil crisis to the gas crisis.

Thank goodness for the Bank of England and monetary sovereignty. Threadneedle Street does heed the money supply – up to a point – and will stop tightening sooner than peers. This will mitigate some of the damage. Sterling will therefore weaken. The usual suspects will weaponise this as an indictment of Brexit, and the usual fools will believe them.

The UK’s recession will not be the worst in the G7 as the financial press keeps telling us. The by-now familiar Brit-bashing from the Parisian OECD will again prove to be overdone, partly because of open-door immigration.

The final tally by late 2023 is that the UK economy will have grown by roughly the same as the eurozone big four since the onset of the pandemic, as it has since the referendum.

Putin may spoil the recovery in the second half by adding an oil crisis to the gas crisis, hoping to foment a political uprising against Europe’s wobbling governments before the attrition of the war finishes him.

He certainly wants to think that is his plan. My presumption is that he won’t dare. It hurts most of the world. He cannot afford to irritate China and India any further, or lose further sympathy in the global south.

My other presumption – low conviction, as hedge funds say – is that the outlines of a settlement in Ukraine will emerge after the Rasputitsa spring thaw, squalid though it may be. It will end in partition along the lines of the 38th parallel in Korea, or rather the 17th parallel in Vietnam, which proved only to be a holding line before the next war. It won’t be durable peace, but it will be rocket fuel for asset markets.

Annus mirabilis? Not quite, but no catastrophe either. Happy new year.

The Daily Telegraph