CONTRIBUTORS
Michael Browne
Investment Strategist,
Franklin Templeton Institute
Last week gave us a chance to compare and contrast how the world’s central banks view the effects of the spike in oil prices caused by the Iran war. US Federal Reserve (Fed) policymakers were looking mainly internally, trying to find a balance of perspectives. Their meeting statement clearly suggests they reached agreement that the current energy price shock as transitory, although inflation is starting from a ‘somewhat elevated’ position. As growth is fine, it was a ‘not much to see here’ statement, which surprised markets, that then reacted with a downward move.
The contrast with the European Central Bank (ECB) was stark: The Europeans cited ‘material impact’ to inflation and raised inflation projections sharply by 0.7% for 2026 and lowered growth expectations to below 1%. The ECB did not use the word ‘stagflation’ but the threat was clear to see. It also cautioned governments from using fiscal levers to offset the oil price shock. While rates were left on hold, the inference was clear that if things stay as they are, the bank will likely raise interest rates as the economy stagnates. The market now believes that there will be at least two, but more likely three, rate increases this year.
The Bank of England’s Monetary Policy Committee (MPC) did not have a press conference but released its minutes with the commentary of the individual members. They expressed concern about inflation and made forecasts that it would be at 3.5% by mid-year. Four MPC members made no reference to growth or ‘activity’ at all in their comments, suggesting that if nothing changes at the next meeting, we will see a rate rise. The market views that as 50/50 chance, but it is now forecasting two increases by July and probably three by December. This was unthinkable just two weeks ago.
So, is the Fed behind the curve, or are the Europeans getting ahead of the curve? The likely answer is that both are true, but the difference emphasises the greater impact that the current Iran war is having on Europe, and that that impact is likely to be long-lasting. This was also true with the outbreak of the Russia-Ukraine war in 2022.
Equity markets have reacted to this swirling news flow by finally getting stuck in the risk-off trade. But how should investors react now? After all, in the middle of the week Nvidia made a series of bullish comments, as life—and in particular, AI—goes on. For investors, the playbook is complex: Tactically markets will likely be oversold, investor positioning will probably become short, and a rally based on traders’ typical contrarian dictum, ‘The market always moves in the direction that hurts the greatest number of participants the most,’ will eventually work. In 2022, European markets experienced oversold rallies in March, May and June, but did not reach the final and lowest low until October. One ingredient that was different in 2022 is that Europe lost, permanently, a major energy supplier in Russia, whereas this year an eventual restoration of previous supplies appears likely.
The fact that the Bank of England and ECB have taken such a hardline stance against inflation is something I view as bullish. Its tolerance for a repeat of 2022 is clearly low, and policymakers are not afraid to raise rates at the expense of growth; the market seems to agree with this approach. As a result, the sell-off so far is not as deep and broad as in 2022. The political will in Europe to end reliance of imported carbon-based energy will be stronger than ever, which will increase interest in nuclear and renewable sources. Bolstering defence spending was already a priority, but events will clearly renew that priority as well. The year 2026 may not be what we had hoped and planned for, but 2027 might actually be better. Growth postponed, rather than growth cancelled.
Parting shot
Spare a thought for the corporate boards and chief executive officers during the upcoming reporting season, which starts after the Easter weekend. Given the uncertainties of the current environment, what on Earth can you say about the outlook, and what will the market believe? This may be a great time for the public relations companies!
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