Summer 2022 will go down in the history books. It was extremely warm and dry – ideal for holidays, trips or simply enjoying the weather outdoors, but a great strain on the environment.
Things were briefly looking brighter on the financial markets over the summer, with interest rates falling and prices rising. This was urgently needed after the poor start to the year, as 10-year interest rates on the capital market had risen by an average of more than 2 percentage points by mid-June. Equities and bonds suffered heavy losses as a result. The value of global financial assets had fallen by over 20 percent in real terms by the middle of the year.
The market recovery over the summer months therefore came as a real boost. Falling interest rates and rising prices provided hope that economic performance and the inflation trend might not be as bad as feared in spring. But any such hopes have now faded. There is apprehension on the financial markets.
Firstly, there are concerns over inflation. The financial markets – driven by stubbornly high inflation rates of more than 8 to 9 percent in the USA and Europe and an unusual rate of over 3 percent here in Switzerland – are very uneasy. A small amount of inflation would not actually do the economy any harm. For example, it would enable sectors that are not performing strongly to reduce their real costs while maintaining constant salaries and avoiding the need for redundancies. However, inflation running at 8 to 9 percent can no longer be described as low. Wages cannot keep pace, even in booming sectors. This will lead to a loss of purchasing power in real terms for employees and, in an extreme scenario, to recession. And this is precisely what is currently creating the second major preoccupation for the financial markets.
For the financial markets to perform well, interest rates should be in line with inflation. However, there is currently a significant gap between inflation and capital market interest rates. This means either inflation has to fall or interest rates have to rise – or both. And the latter scenario looks most likely at the moment. But the central banks are trying to slow demand in the economy and rein in inflation by hiking interest rates. They are even willing to pay the price of an economic slump. In fact, in the monetary policy toolbox, recession is part of the solution to the issue of excessive inflation rates.
However, higher interest rates also mean falling prices, just like during a recession. And that’s precisely the dilemma we face today. For as long as interest rates lie so far below the level of inflation, it will be difficult for the financial markets to mount a lasting recovery. This means that we need to show a little more patience before abandoning our defensive position – even though we firmly believe our investments will generate attractive, positive returns over the medium to long term.