Global markets are tanking ahead of a huge week for central banks

LONDON — Global stock markets are falling sharply after May’s U.S. inflation print reignited fears that central banks will be forced into aggressive monetary policy tightening.

Friday’s highly-anticipated consumer price index report came in hotter than expected at 8.6% annually, resurfacing market concerns that action from the Federal Reserve and other central banks could risk tipping the economy into recession.

Major averages in the U.S. closed out their biggest weekly declines since January on Friday, and futures point to further punishing losses on Wall Street when the opening bell sounds on Monday.

Shares in Asia-Pacific plunged on Monday, with Hong Kong’s Hang Seng index, Japan’s Nikkei 225 and South Korea’s Kospi all falling more than 3%. European stocks also tumbled, with the pan-European Stoxx 600 shedding 2% by early afternoon as a sea of red swept through global risk assets.

Meanwhile, the U.S. 2-year Treasury yield hit its highest level since 2007 on Monday morning and outstripped the 10-year rate for the first time since April, an inversion often seen as indicative of an impending recession.

‘Punch in the gut’

Central to the adverse market reaction to Friday’s CPI reading is the fear that inflation expectations have broadened and become entrenched, beyond the well-documented ephemeral drivers such as supply chain bottlenecks and energy shocks.

“I do think that the probability of falling into a bear market and indeed a recession has undeniably increased as a result of Friday’s punch in the gut, in a way,” Fahad Kamal, chief investment officer at Kleinwort Hambros, told CNBC on Monday.

Kamal added that there was “very, very little good” in Friday’s inflation report, which he said indicated that inflation has not peaked and has instead broadened throughout the economy.

“It’s talked about less in the sex and violence of oil and commodity prices and other things, but actually, rent is very sticky and it’s a huge part of the index. There seems to be upward momentum there as well, implying that inflation is going to be with us higher and longer than we expected even last week,” he said.

Richard Kelly, head of global strategy at TD Securities, told CNBC Monday that both the bond and stock markets were now signalling that a recession is coming down the pike, most probably in the fourth quarter of 2022 and first quarter of 2023.

“Overall, if you look at equity markets, they’re telling you the ISM (U.S. economic activity index) probably falls to 50 or sub-50 over the next two to three months, and in part this is what the Fed and central banks have to do to get inflation back under control,” Kelly said.

The 50 mark separates expansion from contraction in a purchasing managers’ index reading, a reliable gauge of economic activity.

“While (the Fed) can’t sit there and say their job is to end job creation for the moment, that is basically what they need to do if they are going to get inflation back under control now,” Kelly added.

The coming week will be pivotal in the battle against soaring inflation for global central banks and markets.

Federal Reserve officials will meet on Tuesday and Wednesday to discuss their next monetary policy move. The Federal Open Market Committee is widely expected to announce at least a 50-basis-point hike on Wednesday, having already raised rates twice this year, though market bets for a 75 basis point hike have risen in light of Friday’s CPI figure.

The Bank of England’s Monetary Policy Committee will announce its latest interest rate decision on Thursday, while the Bank of Japan, Swiss National Bank and Brazil’s BCB also meet this week.

Investors will also be digesting a slew of economic activity data, including Chinese industrial production and retail sales, U.K. industrial production, employment and retail sales, and U.S. producer price inflation, retail sales and industrial production.

U.K. GDP shrank by 0.3% month-on-month in April, official figures showed Monday, falling short of economist expectations for a 0.1% expansion and furthering fears of an economic slowdown ahead of the Bank of England’s Thursday decision.

“In broad terms, the run of data will be combed for recessionary signals, with the added irony that any signs of activity strength are likely to be a case of ‘good news’ being bad (i.e. putting further upward pressure on rate expectations), while the pressure on central banks is to retain some semblance of control over rate trajectory narratives, despite having been proved hopelessly wrong on inflation,” said Marc Ostwald, chief economist and global strategist at ADM Investor Services International.

Kelly suggested that markets had become complacent in the hope that a deceleration in headline inflation would signal that central banks have caught up with rising prices. He argued that Friday’s data signaled how far behind the curve the Federal Reserve remains, and how persistent inflation is likely to be.

The U.S. dollar strengthened once again on Monday as investors sought the traditional safe haven, sending the greenback surging against most global currencies. Kelly highlighted that TD Securities holds long positions on the dollar against the euro and the Canadian dollar.

“You look at where the rate hikes and pricing are going, you look at equity differentials and it’s telling you to be long dollars,” he said.

“That is something that’s broadening out here, and then that just feeds back into the financial conditions loop in terms of that tightening that then comes back into the growth and the risk side in terms of what the market wants to price into equities and credit.”

On the stock front, Kamal said that while there is no “perfect hedge” against both inflation and a recession, there are steps investors can take to weather the storm. Kleinwort Hambros continues to hold a significant cash weighting and is seeking to deploy it to fundamentally strong, long-term holdings when they hit “attractive prices,” he explained.

“It’s undeniable that in this entire wreckage, there will be plenty of gems. We have increased our allocation to commodities … we may be looking to add to that as clearly commodities are one area which is reasonably good at protecting you from inflation over the long run,” Kamal said.

“If you are in the equity market, it’s really hard to avoid the energy sector right now, because there is clearly a huge structural undersupply of oil and gas and energy equities are still cheap, believe it or not, in spite of a thunderous run-up, and there is still room to run for that sector.”