Humans have a well-documented optimism bias. It has served our species well and serves entrepreneurs well but it does have some shortcomings. Investors often assume a reversion to the status quo and that problems will be quickly resolved. Mostly they are right, but often they are not. When they are not, it can have a profound impact on financial markets.

One of the most recent examples of this was when the market, led by central banks, argued that higher inflation was “transitory”, i.e. was going to quickly revert to previously low levels. In November last year, persistently high inflation data eventually led the Fed, and then the market, to move away from this prediction, and the terminology.

Another example of a lazy assumption was the market’s recent belief, encouraged by gung-ho Western politicians, that Russia would quickly lose the economic war. Russia is indeed struggling economically, in large part due to Western sanctions. However, there are numerous examples globally of economies and societies reeling from higher prices in a range of commodities, brought about by the invasion of Ukraine and the subsequent sanctions.

Indeed, the combination of higher food and energy prices is already leading to financial crises in commodity consuming emerging markets; see how Sri Lanka has defaulted, while Pakistan is struggling too. In our opinion, it is far from clear that Russia is losing the economic war.

That said, not all economies are hurting. This is most evident in emerging markets, as part of the graphic below shows: consumers of commodities are indeed getting weaker but commodity producers are getting stronger.

Higher inflation has many implications

Source: Premier Miton Investors.

As the graphic illustrates, inflation is leading to a number of new dynamics, such as resource nationalism, which is adding momentum to de-globalisation, thereby compounding inflationary pressures.

In year-on-year terms, inflation might have peaked, due to base effects, but that does not mean Fed hawkishness has peaked, with month-on-month inflation less suggestive of inflation pressures peaking.

How inflation feeds into wages is crucial to the persistency of inflation. On this subject, there have been some fascinating developments in Europe recently, with an 8.2% claim for wage settlement in the German steel industry. The country has a system of collective bargaining, so a more collaborative approach between employers and employees. To that end, it’ll be fascinating to see how this is resolved, in part as many trade unions in Germany and the rest of Europe will draw reference from the agreement. Have assumptions for wages growth also been too optimistic too? Time will tell.

All these factors are applying pressure on the coalition against Russia. Firstly, the coalition was never as global or unified as suggested by many. Secondly, the impact on living standards, in part due to the sanctions aimed at crippling Russia, is putting coalition unity under further pressure, we see this clearly in Europe.

What does this mean for policy? Well, in very broad terms, this inflationary backdrop is leading to tighter monetary policy, as central banks try to bring inflation down to low single digits, while there is pressure on governments to ease fiscal policy in order to subsidise the poorer members of society. Meanwhile, the increase in prices in non-discretionary areas like food and energy is leading to weaker growth, as consumers forgo spending on discretionary items.

This is not a great environment for bonds, with inflation hurting government bonds and weaker economic growth hitting corporate bonds. Similarly in equity, many parts of the market are struggling, materials and oils are a rare bright spot.

Central banks are well aware of the issues facing financial markets, for example that the S&P 500 Index has fallen in eight of the last nine weeks. They will be keen to curb inflation without adding to slowing economic growth through a further tightening in financial market conditions. This looks increasingly difficult, as higher inflation means less liquidity for financial markets. It’s not always right to be optimistic.