Where will the nightmare scenario for risk assets come from?

The persistently high inflation will be the biggest danger to riskier assets like equities

There are two issues that stalk the markets: COVID-19 and its impact on growth, and inflation. Last week, it was clearly COVID-19/slowdown risks that unsettled asset prices, alongside the Fed’s taper intentions. But high inflation is by far the more destructive longer-term risk to the market and the more COVID-19/growth concerns escalate the more risks of inflation recede.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy has argued in the past that persistently high inflation is the biggest danger to riskier assets like equities because it threatens to deny the central bank liquidity that has underpinned assets for many years now. If inflation takes hold and central banks like the Fed are forced to lift rates much more quickly and aggressively than the market expects, the world could be headed for a nightmare of both stagflation and a debt crisis. That does not bear thinking about when it comes to risk assets such as equities and corporate debt. This is not to deny that the other threat facing the market, of perennially resurgent COVID-19 and associated economic weakness, is not troublesome. Of course, it is. However, the signs are good that the world is getting on top of this problem and will continue to do so. The signals that rising inflation will prove temporary are more elusive so far and, as we’ve said, potentially more damaging if price pressure stays high. 

For if COVID-19 sticks around for longer than anticipated, and at a higher level than expected, it is likely that central banks will supply more of the liquidity that seems to be the lifeblood of risk assets like equities. Of course, should inflation stay persistently higher and COVID-19 surge as well, risk assets will face the worst of all possible worlds with stagflation and a debt crisis surely around the corner. But the persistence of Covid and its implications for growth could help reduce inflation fears. For instance, we’ve already seen commodity prices tumble as COVID-19 difficulties have helped reduce growth expectations. These declines in commodity prices should feed through to lower inflation, at least at the producer price level where most of the inflation seems to be concentrated at the moment. 

Moreover, if demand declines, it may help to reduce the price pressure that’s coming from supply-chain pressures. Undoubtedly, many of these pressures arise independently of demand surges, and rising COVID-19 concerns can still make the situation worse if labor supply is constrained by lockdowns or worker reticence to return. Nonetheless, it does seem as if surging demand has exacerbated the price strains being generated by supply chain difficulties and, if this demand eases down, so will price pressures.

“Now, none of what we have said so far suggests that risk assets like equities are in the clear. We’ve generally had a cautious view of such assets all year and we are not going to change now. But the point we’d make is that the nightmare scenario for risk assets comes from surging inflation, not surging Covid-19. If the latter reduces the risks of the former, it might at least allow risk assets to flatline the year out, or even make modest gains, rather than tumble as could be the case if higher inflation remains persistent and forces central banks into early and significant monetary tightening”, said Mr. Steve Barrow.