View From Vox: why you should keep your powder dry until a real recovery is in sight

There has been much wishful thinking on display among investors this year, especially in the US where a market rally this summer was driven by the belief that, in the face of deteriorating economic conditions, the Federal Reserve would be forced to curtail its efforts to fight inflation and hold back rate rises.

Such hopes have been brought abruptly down to earth with a bump after the Jackson Hole symposium of US central bankers delivered far more hawkishness than the optimists had expected. 

To sum up the summit in a nutshell, monetary policy will remain restrictive “for some time” until inflation heads definitively back towards the 2% target, no matter the “pain” it will inflict on households. “Reducing inflation is likely to require a sustained period of below-trend growth”, said Fed chief Jay Powell. “We will keep at it until we are confident the job is done.”

Stock markets have unsurprisingly been on the back foot since, with the growth-oriented Nasdaq falling for four straight sessions – five if you count todays US open - in the wake of Powell’s speech, including a 4% drop on Friday. 

The FTSE 100’s old-economy mix of constituents – not least its extractive giants including BP, Shell, and an army of miners - has protected it from the worst of the reversal. But the growing threat of an economic slowdown is checking further progress - energy and metal demand is driven by economic activity, after all, and the reality that activity is waning is starting to drag on the blue-chip index now, too.

To be fair to the bulls, history tells us that over the long-term markets will always deliver the goods for investors, and that a market recovery will arrive before an economic bounce back does, usually by several months. 

Indeed, economic news is almost always a lagging indicator (i.e. measuring things that have already happened) while the stock market is a leading indicator (i.e. a reaction to what participants believe may come in future). The principle, therefore, is that we’ll still be hearing bad news in the press even as actual economic conditions are improving. 

The problem right now is that forward looking economic indicators are telling us that the likelihood is that there is still much more pain to come. The full weight of the European energy crisis, in particular, has yet to be felt by many households and businesses, which suggests a spending squeeze is on the way that will eventually show up in reported corporate earnings, also a lagging indicator.

That’s why recent news of a better-than-expected US reporting season or record dividend pay-outs – mostly driven by excess resource profits - don’t really tell us very much at all, any more than official reports of low levels of unemployment tell us anything about where the economy might be headed. 

Should, as seems likely, we see a slowdown in corporate earnings, that job market strength may evaporate quickly, especially if high energy prices mean prolonged – or even permanent - business closures. Factory activity is contracting around the world, not least in China where a new lockdown in Chengdu reminds us that Covid-related disruptions aren’t yet over. And Russia still has it within its power to further weaponize gas supplies, as it demonstrated with yet another shutdown of the Nord Stream pipeline this week. 

That might be true in the opposite way, of course. Should the energy crisis start to abate more quickly than expected, and we see inflation fall short of predicted peaks – as high as 22% next year according to the latest forecast from Goldman Sachs – a deep recession may be averted. An inventory build and falling demand has already seen European gas futures plunge, albeit they remain abnormally high. A rapprochement with Russia over Ukraine would also ease the current pain.  

That latter point may still be too optimistic. Whatever the case, the picture – both economically and politically - is a confused one, which is why many long-term investors – including myself – have stuck with the safety of cash. Conventional thinking would suggest that in an inflationary period cash will see its buying power reduced – but that’s not the case if it’s earmarked for investing in a market that’s sold off heavily.

I’m very much looking forward to deploying that cash when an objective assessment of economic data suggests the time is right. That may be a while away still, but it gives me plenty of time to keep building up a watchlist of shares I’d like to buy. 

And there are lots of them. A protracted recession and market collapse will see lots of companies pushed to breaking point. But it will also see many good companies thrown out with the bathwater by panicking investors – and ready for patient ones who’ve kept their powder dry to pounce in the sales.