That is just the way it is

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I was asked yesterday what’s the bear case for equities, now the inflation genie looks like it’s back in the bottle. I get the bull scenario, inflation falling, and interests to follow, slowly but surely the economy will benefit from that, and stock markets too. In response, I explained the bear case is not too difficult to understand either, although many a highly paid strategist will use thousands of words to explain when a relative few will do. Inflation falling is a good thing for stock markets if it allows interest rates to fall, the problem will come if, as the Fed and other central bankers continue to indicate they are in no mood to ease monetary policy. This week inflation in the UK fell to 4.6%, according to the latest report, despite this the Bank of England reiterated its view that it’s in no mood to start easing monetary policy. You can now get a real rate of return on your money in the bank, interest rates of 5%, and inflation of 4.6%.

In the US that gap is getting wider, inflation falling to 3.2%, all good news, interest rates above 5%, a real return of 2%. For many a year this has not been the case, for example in Germany bond yields were in negative territory, and you actually paid the German government to lend them money, which seems strange to believe now. Savers had no choice but to find alternatives for capital growth and income.

Why does this matter? If inflation continues to fall, and the central banks stick to their policy of maintaining higher for longer, real interest rates rise further and the attraction for buying alternative assets becomes less. Why risk equities if I can protect my capital in bonds? Also, tighter monetary policy for longer could further slow the economy, adding further risk to earnings. So I want the prospect of a greater return from risk assets to tempt me in. Ergo equity prices must fall to make the entry point more attractive.

It was not so long ago that Chairman Powell would state he was happy for inflation to run “hot” when he was concerned that prices might actually fall as they maintained their ultra-loose monetary policy. Those days are long gone. The Fed was accused of making policy mistakes, not raising rates fast enough, and being too complacent as inflation rates picked up. When they realised their mistake they raised interest rates at one of the fastest paces in history. That may be the story on the way down, slow to cut but then as the economy slows and inflation looks beaten, they cut aggressively, who knows?

Next week is Thanksgiving, traditionally a good time for equity markets. Aside from that after the recent rally that has taken US equity markets back to their peaks this year, it feels hard to find the next catalyst to drive them higher, until the Fed indicates they may be more open to changing interest rate policy.