It took an hour or so for the markets to catch the European Central Bank’s (ECB's) mood last week. Having raised interest rates, the ECB left its commentary unchanged and markets sold off, disappointed that there wasn’t stronger wording of another rise in the pipeline. But I don’t think we should rule out another hike this year, which would put rates at 3% by year-end.
Suddenly, the ECB is positioned as the world's leading hawk. The question is, what difference will it make?
Let’s look back at the period of 1995 to 2000, when the US Federal Reserve continually raised interest rates. Former chair Alan Greenspan, in his most memorable quote, talked about ‘irrational exuberance' in 1996. That speech was four years before the ‘dot-com boom’, which was in its very early infancy, went bust in 2000.
The strength of the economy, recovering from the property crisis of the late 1980s and early 1990s, overwhelmed the rising cost of money, and equities led the way higher. Then the dot.com bubble appeared; we all knew that the world had changed, we just did not know how to value it.
The parallels with the second half of the 1990s to today are quite striking – namely, the pickup and broadening of the equity markets in response to resilient and reliable growth.
We saw warnings from central banks as they raised rates. In the United States, it was the end of a political era: Clinton replacing Regan/Bush. In the United Kingdom, Blair won a landslide after 18 years of Thatcher and Major.
War in Europe produced horrific massacres – Srebrenica being the worst – and no one knew how to stop it. Mexico had a debt crisis, Russia collapsed and its debt crisis there and in Asia sparked the ruin and rescue of long-term capital management. A young new president named Vladimir Putin restored stability to Russia.
We are clearly looking at the changing of the political guard, starting with Donald Trump in the United States and Giorgia Meloni in Italy, but we have also seen reversals in Poland and Hungary. Germany appears to be next and France could follow. War in Europe continues and, with it, untold levels of death and casualties.
In spite of global issues, for the markets, earnings were (and are) the most important driver in the long run. We are beginning to look at a debt crisis in several countries around the world and the one most worry about is in the artificial intelligence (AI) space, with circular financing and opaque lenders from a variety of sources.
But we also have one of the strongest earnings recoveries we have seen in decades, particularly in Europe.
There are some good omens about today as well. Equity rallies after midterm elections are well known, well documented and consistent, and we have US midterms coming up in November.
The fear that equities will underperform after a heavy initial public offering (IPO) issuance year should be tempered by the fact that as a proportion of the equity market, this year the IPO calendar is actually quite light.
Bond markets are pressuring governments to temper their deficits, and whilst some state balance sheets carry two or three time the amount of debt as a percentage of their gross domestic product, leverage is light in the corporate and household sectors.
Even within the AI space there are cashflows, at least in the quoted stocks. It all suggests to me that as long as the bond markets impose discipline on governments, interest-rate rises are not to be feared.
That's not to say that investment returns will match those of the last couple of years, in particular outside of the United States. The bond markets have had another difficult year for returns, but curve steepening is great for financials, and the broader market.
And if any of this feels uncomfortable, it is. There will be more volatility, though perhaps within a tight range. Until the yield curve flattens, equities will carry the flag.
Markets can stay exuberant longer than any rational man could believe, as long as the economies as a whole are performing well.
Michael Browne is global investment strategist at Franklin Templeton Institute. The views expressed above should not be taken as investment advice.