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The worst-case scenario for next year is if the Powell Fed becomes another Volcker Fed, if it becomes more hawkish, says one fund manager.EVELYN HOCKSTEIN/Reuters

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Inflation is finally cooling. But the ghost of sky-high inflation continues to haunt fund managers.

The genuine possibility that the peak in global inflation may be behind us started to emerge in the U.S. last month, when data showed the annual rate dropped to 7.1 per cent in November, a decent fall from 7.7 per cent in the previous month and even a little below forecasts.

Certainly, the “old you” from, say, three years ago, would laugh at the suggestion that 7-ish per cent inflation is good for risky assets. But then, “old you” had not been through the mincing machine of 2022 – a year that fund managers of almost all stripes are desperately keen to forget.

That reading marked the slowest rate of inflation in almost a year and meant the pace of consumer price rises had fallen back for two months in a row. It enabled investors to dare to hope that the long nightmare of endlessly soaring inflation and an endlessly hawkish U.S. Federal Reserve Board might finally be coming to an end.

In January, data from the eurozone suggested the U.S. inflation figures were not a blip when its December rate also dropped back into single figures. U.S. figures for December are due out this week.

So, why are investors not dancing in the streets? Instead, party-poopers, perhaps humbled by a cruel 2022 marked by the killer combo of both sliding stocks and bonds, express nagging doubts when you ask how this year will pan out.

“Honestly, I don’t know,” says Andrew Lake, head of fixed income at Mirabaud Asset Management Ltd., with a hint of a sigh. “I have no idea.”

One factor holding back the enthusiasm is that a pullback in inflation was already embedded in markets. Investors had done what they are supposed to do and anticipated the next big shift in the global macroeconomic environment.

Global stocks, as measured by the MSCI World Index, climbed by some 20 per cent from the lowest point of October to mid-December despite the lack of any meaningful brightening in economic growth or geopolitical tensions. That rally “took a lot out of returns from [2023],” Mr. Lake says.

The really big worry for Mr. Lake, and for lots of other fund managers, is that, sure, the Fed will probably hit pause quite soon. It has already chopped the size of its interest rate increases down to a half point, a break from the three-quarter point increments that we saw several times over 2022. Early this year it is likely to want to sit back and see how that rapid pace of tightening filters through the economy.

But can we be certain that the next move is down? What if the pause is not so much of a pivot but a plateau, a brief breather to reload and start again? After all, it turns out no one in policymaking or investing circles really understands inflation quite as well as they thought.

“If inflation doesn’t come down and unemployment is not high, then they will feel comfortable raising rates again,” Mr. Lake says.

This is the notion really keeping investors awake at night. Deep down, they want to get back to the good old days of low inflation, low interest rates and central bankers who see a virtue in supporting highfalutin-sounding financial conditions (for which, read buoyant asset prices).

But central bankers want to get back to a different sort of good old days when inflation was housebroken. If they remain single-minded in this mission and fire up interest rate rises all over again, then some of the nastier features of portfolios in 2022 could reassert themselves in 2023.

“The worst-case scenario for next year is if the Powell Fed becomes another Volcker Fed, if it becomes more hawkish,” says Flavio Carpenzano, fixed income investment director at Capital Group.

Not only would that continue to throttle higher-risk assets such as tech stocks that thrive when money is cheap and profits are a worry for another day, but it would also be likely to force the U.S. economy into a recession.

“My biggest worry is that the Fed has to start again,” says Andrew Pease, head of investment strategy at Russell Investments.

It’s easy to imagine the Fed pausing, markets shooting higher, the economy picking up, Mr. Pease says, followed by a resurgence in the inflation that policymakers are so desperately keen to hold down. And then the pain restarts.

“My worry is not that we get a big recession, it’s that the Fed starts tightening again at the end of 2023,” he says.

A mild recession might, in fact, be the best outcome for investors, he says – mild enough not to inflict too much pain but bad enough to keep the Fed’s endpoint for benchmark rates well under 6 per cent.

Otherwise, the horror show of 2022 will just keep rolling. Last year was “seen as the year of the reset,” Mr. Pease says. “What if it’s not?”

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