Occam’s Razor and the state of financial markets

Investors shouldn’t be surprised if an abundance of optimism proves to be fleeting.

Fourteenth century philosopher William of Ockham provided a great service to today’s investors seeking to understand the current state of financial markets. To crudely summarize his seminal thesis that became known later as “Occam’s Razor,” phenomena are best explained by the simplest hypothesis possible. With that principle in mind, let’s try to figure out what markets are telling us.

It goes without saying that the global economy has a problem with unacceptably high rates of inflation. Future improvements aren’t visible yet because no inflation data reported so far this year didn’t surprise to the high side. Combatting inflation is now the sole focus of central banks around the world, so they’ve rapidly hiked short-term interest rates and reduced the size of their balance sheets. The U.S. Federal Reserve has been particularly aggressive in its inflation fighting efforts with a series of 50- and 75-basis-point rate hikes. Those hikes have been very large by historical standards, and they’ve also started to unwind emergency stimulus programs implemented during the COVID-19 crisis.

In July, market interest rates responded to central bank tightening by … wait for it … falling across the maturity spectrum. Stock markets also rallied during most of the month. Investors now seem to expect reductions in economic growth and excess demand much earlier than previous estimates, and that will force central banks to quickly pivot away from fighting inflation. Under that scenario, bad news about the economy is good news for investors because it means central banks will have achieved their inflation goals ahead of schedule and will soon turn to supporting growth with easier monetary policy.

 

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