Investors are running out of room to hide

There's barely elbow room left in the year's dominant investment shelters.

That begs the question: What would a further setback for the world economy mean?

Tuesday's surprisingly sticky U.S. inflation reading for August knocked back hopes that a durable turn in the largely energy-driven inflation of the past year would allow the Federal Reserve to ease its foot off the interest rate brake.

For those who fear the Fed, it's now worse than the nadir of this year's stock market plunge in June.

An uncomfortable re-acceleration of 'core' consumer prices that exclude energy and food cemented expectations for another 75 basis point Fed rate hike this week.

More significantly, it pushed the expected "terminal rate" for this Fed rate cycle as high as 4.25% by March next year — a quarter point higher than priced at the depth of bearishness around midyear. What's more, futures now see no return in rates back below 4% for at least 12 months and two-year Treasury yields hit as high as 3.75% for the first time in 15 years.

With European headline inflation peaks still to come and central bank tightening going up a gear there too, the risk of another investment setback is considerable going into winter — with little visibility on either the extent of an energy crunch or the upshot of the geopolitical standoff with Russia over Ukraine at the heart of that problem.

Dash back for the investment bunkers and buy dollar cash? That was certainly the knee-jerk again on Tuesday following the inflation surprise, as Wall Street stock benchmarks plunged back to within 10% of their June troughs and the recently ebbing dollar was re-energized back toward 20-year peaks.

But apart from speculative short-term flows, there doesn't appear to be much room left in those bunkers and fund managers en masse appear to have barely ventured forth at all over what seemed to be a tentative market recovery in the third quarter.

Bank of America's September survey of global fund managers, conducted before Tuesday's inflation jolt, showed average cash balances rising to 6.1% — the highest since the aftermath of the 9/11 attacks and dot.com bust in 2001 and far above long-term average cash holdings at 4.8%.

Describing investor sentiment as "super bearish," BoA's survey showed positioning in world equities at a record underweight — more negative than during the crash of 2008.

Dolan is a columnist for Reuters.