In the UK, the government’s fiscal event on 23 September swiftly morphed into a significant monetary event as the credibility of the new fiscal plan was challenged by investors. The disorderly sale of gilts increased the ‘risk free’ discount rate, which is used by investors as the starting point for valuing investments and this, therefore, began to call into question the valuations of investments across all UK focussed asset classes. The Bank of England was forced to step in and announce a bond buying program to settle nerves on 28 September.
Since then Sunak and Hunt have been installed in the roles of Prime Minister and Chancellor of the Exchequer and their renewed commitment to ‘sound money’ has settled investors’ concerns. Gilt prices have risen appreciably such that the lower borrowing costs that the UK government had over the USA over the past five or so years has been restored.
The asset price volatility created by these events made valuations more appealing, especially in fixed interest where there is an ongoing transfer of value from borrowers (companies and individuals) to lenders (financial services companies and fixed income investors) as interest rates rise.
Looking forward, across all developed market economies, the good news is that headline inflation is likely to start to fall from current elevated levels (assuming no additional disruptions from those currently known). Indeed, the falls could be fairly swift during 2023 due to falling energy prices and slowing food price rises. Other prices, such as industrial metals, have also fallen appreciably from the highs seen during the immediate aftermath of the Russian invasion of Ukraine.
However, core inflation (inflation excluding food and energy prices) is likely to remain elevated in developed markets for some time to come as wage rises continue to climb. This will show up most obviously in the service sector inflation numbers. This will be mitigated, to some extent, by a reduction in goods inflation as supply chains normalise and companies look to clear high stock levels. Overall, we anticipate headline inflation will fall below core inflation during 2023.
Developed market central banks are focussed on policies which are designed to reduce core inflation and are expected to increase interest rates materially from current levels in order to reduce demand.
Falling demand, allied with improving supply chains, is likely to put pressure on company margins as competitive pressures reassert themselves following the COVID-19 related (release from lockdown) boom in demand. We anticipate that company earnings forecasts for 2023 and 2024, which have remained resilient, will be revised down.
This means that during 2023 investors are likely to see, concurrently, the positive tailwind of falling headline inflation and the negative headwind of falling earnings estimates. We believe that, at least initially, falling earnings forecasts will dominate the news concerning falling headline inflation. The reason for this view is that central banks are unlikely to pivot away from increasing interest rates until there is tangible evidence that labour markets are softening and by then developed market economies will already be in recession.
It’s important to note that the coming recession is likely to be a ‘normal’ cyclical recession rather than something more sinister. Banks are strongly capitalised and so can withstand the economic slowdown far better than, say, during the great financial crisis (GFC) of 2008/09. During recessions banks tighten lending standards, which is pro-cyclical and amplifies slowdowns. This time round the tightening of lending standards should be far less dramatic than during the economic crises of the recent past.
When evidence emerges that the US labour market is beginning to soften, investors will start to anticipate the Federal Reserve beginning to reduce interest rates. When this happens, equities are likely to perform strongly.