The new year starts with most advanced economies either in, or approaching, recession. The enormous monetary and fiscal stimulus of the COVID period secured an unprecedented bounceback from the steepest recession ever. But that stimulus has driven aggregate demand above aggregate supply (still scarred by COVID) in many countries, kindling inflation; and Russia’s pointless invasion of Ukraine has fuelled the inflationary fire. Meanwhile the support to financial markets from ultra-loose monetary policy has been removed, as central bankers focus on restoring inflation to target.

One way of assessing the bearishness of investors as the new year begins is to look at the put/call ratio.[1] Currently this ratio is, on the face of it, more bearish now than at any time since the Great Financial Crisis. Of course, the reversal has coincided with Powell’s hawkish position on rates and QE, which was effectively a removal of the free put option that the Fed had issued to markets from the GFC onwards. With that removed, market participants now have to pay for the same option, and that is what they are doing. It is possible that they were just as bearish before, but felt protected by the Fed put. It is prudent to take this signal into account when thinking about your asset allocation, but there are technical factors influencing this ratio too that suggest the outlook for equities is probably not as bad as this signal alone might suggest.

For a start, it turns out that the bearishness apparent in that ratio is not consistent with the news on corporate profits, which remain robust, especially as a share of GDP.

Energy and food prices were the primary drivers of higher inflation in 2022. The worst of the news on energy prices (both wholesale and those paid by consumers) already appears to be in the past for the US, although price falls may not be as immediate for consumers in the euro area, the UK or Japan. Meanwhile, food prices are still very high globally, though they have come off their peaks. This level of food prices, if maintained, is likely to create stresses in many developing or less-developed countries, where they are a good predictor of conflict and financial crisis, but less so in advanced economies like the US.

But other commodities such as base metals appear mostly to have decisively passed their peak prices for now. Much hinges on the short-term outlook for China, which will improve now that COVID restrictions have been relaxed. In certain key commodities, though, the story is different — lithium prices, for example, remain sky high in line with demand for electric vehicles.

In the US and China, inflationary pressure in the round appears to be waning; the same is not yet true in the euro area, the UK and Japan. True, this week’s euro area inflation data for December saw the headline inflation rate falling to 9.2% from 10.1% in November, with declines across Germany, France, Italy and Spain. Equity prices have responded positively this week, but the ECB’s fight is certainly not over – core inflation rose by 0.2 percentage points to 5.2%, demonstrating the strong underlying demand.

Fathom’s central forecast has inflation drifting slowly back down towards the target in all countries over the coming two to three years. But that is by no means a certainty in all countries. The UK stands out to Fathom as most vulnerable to an extended period of high or even rising inflation, with wage increases comfortably in excess of the sum of productivity growth and the inflation target, despite shrinking economic activity.[2]

As the chart below shows, the risk of such an outcome cannot be written off even in the US. The experience of the 1970s showed that the inflationary flames from higher energy prices can start to fade, only to be stoked again by second-round effects through wages and other costs — aggravated in the 1970s by another energy price shock at the end of the decade.

The inflationary fire was only finally put out by the Volcker period, and by the recession induced by the monetary tightening he oversaw. It is too soon to be sure that Powell has yet doused the flames in the way that Volcker did. Watch this space.

[1] Puts offer investors protection against falling equity prices by offering the chance to sell at a pre-specified price. Calls do the opposite, offering the chance to benefit from a rising market without tying up the capital needed to purchase equity. The put/call ratio tracks the relative number of each type of contract being traded.

[2] Refinitiv users can see more on UK developments in the ‘UK Mini-Budget’ Hot Topic folder on Chartbook.

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