Investors in equities and other risky asset classes are struggling to find good news, for the short term, at least, that would provide a lasting boost to their risk appetite? Don’t worry, though, readers. If this really is the case, things should improve before too long.

However, even asking this question highlights the unusual nature of the current economic cycle. Usually, during a period of sluggish growth and rising official rates, bad news about business activity and demand is often welcomed by the stock market, as it often causes central banks to take a more cautious approach during their monetary-tightening cycle.

However, the current situation is very different. As a result of a combination of supply and demand shocks, the European Central Bank and the US Federal Reserve have (temporarily, we hope) lost control of inflation. Therefore, good news about the economy  -demand, activity, the labour market- is conversely being treated as bad news by financial markets and central banks because it could slow down disinflation and therefore justify further monetary tightening. In addition, bad news is not necessarily being welcomed by markets either as it does not offer a great deal of hope for a less aggressive monetary policy, as this is primarily based on the inflation outlook and because, in the current climate, lower growth may not inevitably push down inflation quickly. Only a significant fall in demand would accelerate disinflation. However, it is highly unlikely that investors would react favourably to a strong recession, even if it meant the end of monetary tightening or a return of rate cuts. Their concerns would then move to the negative effects on corporate earnings.

However, this situation where virtually any news about the economy is seen as bad news cannot last. The change of stance should primarily be driven by inflation. The growing belief, shared by investors, that the deviation from the central bank’s target will decrease, as a trend, should fuel their risk appetite, even if this gap is still substantial. After all, it is the strength of these disinflationary dynamics that matters. It could result in central banks adopting a less aggressive stance and indicating when official rates have reached their cyclical peak. This would stabilise the bond market and would support equity markets.

Some recent data in the United States and in the eurozone are encouraging. Freight costs and raw material prices have dropped over recent months, reflecting the large drop in congestion at ports and the downward revision of growth prospects. Delivery times are shortening, the percentage of companies facing increased input costs is declining and fewer are planning to increase their sale prices. By contrast, wage increases in the United States are still strong and should accelerate further in the eurozone.

It is important to make a distinction between the level of certain economic data and their recent dynamics. When it comes to the survey data above, the dynamics are good (they indicate receding upstream inflationary pressures) and they are consistent with the traditional relationships between economic variables: as a result of abating pressures on input costs and the slowdown in new orders, companies are less inclined to increase their sale prices again. However, starting from an extremely high number, a very large net percentage of companies are still considering increasing their prices, despite the recent dip, as a recent study published in Germany further illustrates.

Therefore, the real issue for 2023 will be not so much the fall in inflation, which is hardly in doubt, with slowing growth, easing supply tensions and favourable baseline effects coming into play. Instead, it will be how quick or slow this decline will be. The slower the disinflation, the greater the risk that household and business inflation anticipations will remain too high. Similarly, the more central banks feel obliged to increase their interest rates, the greater the risk the cumulative rate hikes will hamper economic growth and profits. In the short term, investors will keep focussing on price dynamics, but, as the latter return to normal levels, they will shift their attention to the growth outlook.

Reproduced with the kind authorisation of L’AGEFI