Why biggest risk is market 'scaring itself' over central banks' reaction

Investment strategist fears patience will run thin when inflation picture begins to settle

Why biggest risk is market 'scaring itself' over central banks' reaction

The biggest risk to capital markets right now is how the central banks navigate the next few months, Mackenzie Investments’ Investment Strategist told Wealth Professional, while making some portfolio recommendations.

“I’m less concerned that the central banks will overreact. I’m more concerned that the capital markets, the stock market in particular, may scare itself into a bit of a fit, thinking that the central bank is either not reacting enough or is overreacting,” said Brent Joyce.

“My fear is that the capital markets won’t be patient enough with them in the next three to five months, when things begin to relax a little on the fear around inflation, and that we could have some volatility, just out of the notion that they might make a mistake, even though they don’t end up actually making a mistake.”

Joyce said the real concern is how much disruption the global economy must work through with the collision of excess demand, given that businesses and households have done better than expected in navigating the pandemic and the government’s large fiscal and monetary response, and the supply chain issues that have occurred and may occur again. 

“The magnitude of this disruption is like nothing we’ve seen before. It’s well above any trend that we’ve seen in decades,” he said, noting how much people are shopping online to occupy themselves and the central banks are using new tools or expanded mandates to address the quality of employment and how it’s equitably distributed across the income strata. “These are things that central banks haven’t had to do before.”

He said that, plus inflation being well above target, is “a bit of uncharted territory, and it makes me more concerned”, though early indications in late 2021 were that the “Fed is going to get it right and the market believes the Fed.”

Joyce was somewhat optimistic, though, since he noted the central banks are data dependent and the markets are getting better at understanding that, even if the capital markets can be impatient. He was concerned that if the banks release a bad data point or inflation runs a little harder for a little longer, “the market may run out of patience sooner than the central bankers do. Even though I think patience is the right course of action.

“That’s not to say that’s a disaster scenario for markets. It just means we’re likely to see a good old-fashioned correction, which we haven’t seen in a long, long time.”

Joyce was also optimistic about the global GDP growth expectations of 3.5% for Europe and North America, which are well above the usual 2% to maintain equilibrium. That, coupled with business investment in supply chains to address that, rising wages, pent-up household savings, a lot of cash on corporate balance sheets means that there’s a lot of fiscal spending coursing through the global economy and the earnings growth will support stock prices, though the numbers may be lower – even though there’s still concern about the impact of another variant.

Mackenzie expects the central banks to raise rates in the latter half of 2022 and equity gains to normalize and flatten out to high single digits by Labour Day, though Joyce recognized that variations around that may feel like volatility for investors expecting a repeat of the spectacular 2021 rates.

Joyce said Mackenize is recommending a neutral stance through this period with government bonds the best tool to hedge against the volatility since it thinks there’s a place for them in portfolios. It’s also worth digging into the narrow credit spread pick-up in investment grade bonds, and looking at leveraged loans and floating rate instruments in the high-yield space as they can be important in a rising rate environment with a bit of elevated inflation for a period of time.