GRIMALDI & PARTNERS – How will the central banks react to inflation and what effects are to be expected for the financial markets?

von Silvano Grimaldi, Grimaldi & Partners

How will the central banks react to inflation and what effects are to be expected for the financial markets?

Zurich - How will the central banks react to the inflation trend? What impact can we expect on the bond and equity markets? Silvano Grimaldi, CEO of the independent asset management company Grimaldi & Partners AG, will answer these questions.

Fears of inflation reawakened

The inflation rates have risen in the last few months compared to the previous year to levels not reached in years. Although these inflation rises are essentially due to base effects caused by the pandemic crisis, temporarily disrupted supply chains, supply bottlenecks and the increasing demand for raw materials, the expansion of supply not only taking place quickly enough, this development not only led to inflation fears among many investors, but also to the announcement of possible reactions by the US Central Bank (FED) and the European Central Bank (ECB) on the inflation trend.Causes of the current price increases

A large part of the current rise in inflation results from price changes in a few sectors of the economy. The ongoing upward pressure in price developments comes mainly from the supply side due to temporary bottlenecks. However, the effects of these bottlenecks were stronger and lasted longer than was generally expected at the beginning of the year. On the demand side, however, the price pressure has already weakened noticeably. Most central banks therefore continue to assume that the currently observed inflation rates are temporary phenomena. Due to the adverse effects of the economic catch-up effects that have occurred and in some cases still persist after the corona pandemic - e.g. in the recruitment of qualified workers, bottlenecks in the procurement of preliminary products for industrial production, increasing protectionist tendencies, etc. possible second-round effects (e.g. higher wage demands) mean that inflation rates remain high for a little longer than was previously expected by central banks and the players in the financial markets.

Reactions from the US and European central banks

The Fed and ECB have announced that they will gradually reduce their bond purchases (tapering). However, she has not yet given a date for the start and the extent of these measures. Quite a few players in the financial markets expect, however, that the US Federal Reserve's Open Market Committee will initiate a gradual reduction in the bond purchase program in its first meeting after the labor market report was published on October 8th for the month of September. However, interest rate hikes are only to be expected after the bond purchases have ended - i.e. certainly not before the end of spring 2022 - if full employment really does then prevail in the USA. The ECB will follow the US Federal Reserve with comparable monetary policy measures. But it, too, is likely to have learned from the mistakes made in 2011 - two rapidly successive increases in key interest rates in the expectation of permanently rising inflation rates due to the hoped-for significant economic recovery, which then led to a renewed economic slump in the euro zone - and therefore the main causes take into account the current rise in inflation in their decisions.

Effects on bond and equity markets

The current development of yields on the bond markets shows that investors' concerns about interest rates and inflation have decreased somewhat. Investors are turning to bonds again, prices are rising and yields are falling. If it turns out that, contrary to expectations, inflation rates will not decline and the central banks are forced to raise key interest rates, there will initially be price losses, especially for government bonds. However, inflation expectations, the relationship between the supply and demand of capital, are the far more decisive determinants of longer-term interest rates. However, the global savings overhang will not be rapidly reduced and long-term rates will therefore remain low.

In terms of historical valuations, stocks are usually considered expensive, but prices for virtually all assets have risen massively in recent years. In times of rising prices, companies can usually improve their profit margins. The expected more moderate inflation rates will also continue to support share prices and speak in favor of maintaining high share quotas. Equities will remain more attractive than bonds for a long time to come, as monetary policies will remain loose and capital market rates will remain low. The low nominal interest rates and the resulting discount factors therefore continue to speak in favor of growth stocks, namely stocks of enterprises with a strong focus on future growth.

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