Growth has been irrepressible – but inflation is unlikely to go away on its own
Growth has been irrepressible, evading expectations of recession through good weather, confident US consumers and supportive government policies.
There has been lots of change over the past few months. A warm, windy, and wet winter has averted the energy crisis in Europe, while in the US the consumer has brushed off bad news and continued spending its ‘Covid piggy-bank’. Governments have helped avert the energy crisis in Europe and ended lock-downs in China.
While falling energy costs will cut headline inflation back from record levels, underlying inflation is still two or three times the 2% target for central banks. Continuing economic growth, record lows in unemployment and wage pressures will all support core inflation well above target.
The consensus is still for recession. Central banks have still got their eye on inflation, which is unlikely to go away of its own accord. More rate hikes are forecast and that inevitably means that recession remains the most likely outcome.
However, any recession should be mild and short. Structural economic imbalances, which trigger protracted recessions, are missing. The ‘Covid piggy banks’ remain significant and, in Europe, completely untouched, allowing for a rapid recovery once consumers regain confidence in the economic outlook.
Inflation US, EZ, UK and France
Consumer price inflation % year on year
Source: Columbia Threadneedle Investments and Bloomberg as at 16 February 2023
US consumer seems unstoppable.
US consumer has brushed aside a housing crash that would have normally brought the economy to a juddering halt. The key factor has been the confidence to spend accumulated ‘Covid piggy-banks’.
This has left the Federal Reserve apparently firing blanks. However, temporarily offsetting or postponing the impact of monetary policy is not the same as avoiding it. The Fed is also not out of bullets.
We continue to believe that to engineer the required reduction of inflation, the Fed will raise interest rates until wage inflation is choked off by job losses. That usually means a recession, while we can’t rule out a soft-landing we wouldn’t predict such a fortuitous outcome.
However, any recession is likely to be mild and short and we see a swift recovery once inflation forecasts are back in line with the Fed’s target.
US consumers keep spending despite real income squeze
Source: Columbia Threadneedle Investments and Bloomberg as at 3 February 2023
Negative sentiment on Europe means that good news is dismissed as ‘just lucky’.
Sentiment among consumers has hit record lows in Europe. That seems to have also infected investors. As consequence the warm, windy, and wet weather that averted the energy crisis seems to have been regarded as a piece of one-off luck.
However, this ignores the successful policy intervention by governments to insulate economies from the worst of the energy crisis and the massive supply and demand response to the huge energy price shifts. Germany hit its target to cut gas and electricity consumption by 20%. These successes mean that Europe is much better placed to weather the next winter, especially as lower energy prices feed into better finances for both government and consumer.
The lack of recession does leave the European Central Bank with more to do to control inflation. However depressed consumer confidence means there’s scope for inflationary pressures to fall out of the system as energy prices fall back.
With unspent ‘Covid piggy-banks’ in reserve, there’s a great opportunity for a self-reinforcing cycle of recovery and rising consumer confidence to surpass current depressed expectations.
A year ago recession seemed unlikely … today it’s the base case
Consensus forecast probability of recession in the next 12 months
Source: Columbia Threadneedle Investments as at 16 February 2023
The turnround in the outlook for the unloved UK could be even more dramatic.
We are overweight UK equities, reflecting their defensive nature, low valuations, and scope for a UK turnaround to surprise investors with its strength.
A recession is still expected in the UK in 2023, with house prices falling and consumer confidence having hit record lows. The economy has also been battered by strikes and so growth has lagged its peers. Unsurprisingly investor sentiment is also negative.
I expect the Chancellor to concentrate on measures to further cut headline inflation at this Budget, with strikes and wage negotiations ongoing. However, falling gas prices have removed a subsidy predicted to cost £70bn per year. This leaves plenty of scope for significant measures to boost recovery next year with announcements starting in the autumn.
With unspent ‘Covid piggy-banks’ in reserve, there’s a great opportunity for a recovery in consumer confidence to drive a self-reinforcing cycle of economic recovery.
Consumers are deeply depressed in Europe
Source: Columbia Threadneedle Investments and Bloomberg as at 3 February 2023. Z-scores with mean and standard deviation only from Jan 2000 to December 2019 to remove distortions over Covid period. US references the Conference Board Consumer Confidence series, Europe the European Commission Consumer Confidence indicator, and UK the GFK UK Consumer Confidence indicator.
With growth and inflation set to fall, we like government bonds.
Real yields are at high levels, as central banks push up interest rates to control inflation. As we expect these efforts to be successful, we would prefer fixed-interest over inflation-linked bonds.
The recent shift of investor expectations to discount a soft-landing for the economy have meant that yields on government bonds have drifted up again, adding to their attractions. We would favour government bonds over corporate bonds, where the yield premium for credit risk has fallen back sharply from last year’s peaks.
We are neutral on equities. Despite current negative investor sentiment, we expect equities to still struggle in the near term, in a recession. However, our expectation that any recession will be short and mild means that we would anticipate a swift recovery thereafter. A recession is therefore likely to throw up attractive investment opportunities in economically and interest rate sensitive assets, like property and high-yield bonds.
Enormous changes in 10 years real rates
Source: Columbia Threadneedle Investments and Bloomberg as at 16 February 2023
