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Aug. 6, 2022, 4:00 p.m. EDT

Four fairy tales that stock market investors and economic policy makers are telling themselves

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By Anatole Kaletsky

LONDON ( Project Syndicate )— Do you believe in fairy tales? If so, you could probably earn good money nowadays as a financial trader or gain power and prestige as a central banker.

While annual inflation in the United States, the eurozone, and the United Kingdom has soared to 40-year highs and will probably hit double digits after the summer, financial markets and central banks  seem confident  that the war against surging prices will be over by Christmas and that interest rates will start falling by next spring.

Everything is just right

If this happens, the world economy will soon return to the financially perfect conditions of the Goldilocks fairy tale that has entranced investors for the past decade: neither too hot nor too cold, and always just right for profits.

Investors’ optimism can be seen in the trillions of dollars staked recently on three closely related market bets. Money markets are now  predicting  that U.S. interest rates /zigman2/quotes/210002368/delayed FF00 -0.0052% will peak at below 3.5% in January 2023 and then decline starting from next April to around 2.5% in early 2024. Bond markets /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +2.77%   are priced  for U.S. inflation to collapse from 9.1% today to just 2.8% in December 2023. And equity markets /zigman2/quotes/210599714/realtime SPX -1.72% /zigman2/quotes/210598065/realtime DJIA -1.62% /zigman2/quotes/210599024/realtime GDOW -1.04% assume that the economic slowdown that causes this unprecedented disinflation will be mild enough for U.S. corporate profits to  increase by 9% in 2023  from this year’s record levels.

Central bankers are more nervous than investors, but they are reassured by their economic models, which are still based on updated versions of the “rational expectations hypothesis” that failed so miserably in the 2008 global financial crisis. These models assume that  expectations  of low inflation are the key to maintaining price stability. Central bankers therefore see “well-anchored” inflation expectations as  evidence  that their policies are working.

When central bankers and markets follow each other, both are likely to be led astray. But this only partly explains financial markets’ willingness to bet against  warnings  by eminent commentators such as Larry Summers, Mohamed El-Erian, Jim O’Neill, and Nouriel Roubini of a return to 1970s-style stagflation.

Buy on the sound of cannons

I have just spent three months traveling around the world to discuss with hundreds of professional investors why I also have shifted to an unequivocally bearish outlook, after a decade of Panglossian optimism about financial markets’ prospects. These discussions have convinced me that today’s investor confidence rests on four fallacies, or at least cognitive biases.

The first cognitive bias is to downplay and defy geopolitics—a view summed up by Nathan Rothschild’s  legendary instruction  in the Napoleonic Wars to “buy on the sound of cannons.” Professional investors take pride in trading against panicky retail investors who sell their assets because of wars.

This contrarian approach has often proved right, though with one glaring exception. The October 1973 war between Israel and a coalition of Arab states led by Egypt and Syria permanently  transformed  the world economy in ways that ruined a generation of overconfident investors. They downplayed events that are eerily reminiscent of today: an energy shock, a surge in inflation after a long period of monetary and fiscal expansion, and bewilderment among policy makers who simultaneously faced high inflation and rising unemployment.

Squeezing Russia, one of the world’s largest producers of energy /zigman2/quotes/209723049/delayed CL00 -1.18% /zigman2/quotes/210189548/delayed NG00 -3.34% and many other commodities, out of global markets has triggered a supply shock that is at least as serious as the 1973-74  Arab oil embargo  and will last for years. Restoring price stability will therefore now require a long-term demand constraint tough enough to match the commodity supply reduction. That implies an increase in U.S. interest rates to 5%, 6%, or 7% instead of the 3.4% peak that investors and central banks now assume. Yet, investors’ Pavlovian reflex is to downplay this geopolitical upheaval and focus instead on small adjustments in U.S. monetary policy.

The trend is your friend

This stance reflects a second cognitive bias, summarized in the investment adage “the trend is your friend,” which implies that  changes  in market-moving economic indicators such as inflation, unemployment, or interest rates are more important than their  levels .

Many investors accordingly believe that monetary conditions have become very tight because central banks have raised interest rates in increments of 0.75 percentage points instead of the usual 0.25 percentage points, despite the fact that rates are still much lower than in any previous tightening cycle.

Similarly, investors seem unperturbed by inflation rising above 9% because they expect it to fall to “only” 7% by December. But businesses and workers in the real economy will still see prices rising at their fastest rate in decades, which is bound to drive corporate pricing strategies and pay negotiations for 2023.

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