2022 saw much of the received wisdom around investments of the past 20-plus years turned on its head.
Inflation reached double digits as COVID related pent-up demand met the reality of coronavirus related supply chain disruption, which was then exacerbated by the war in Ukraine that stimulated both an energy crisis and food price inflation as the cost of fertiliser spiralled higher and the supply of grain was threatened.
Tight labour markets (due, in part, to COVID related exits from the work force) and elevated inflation have led to higher wages in the private sector and has stimulated the public sector to demand better wage rises than those offered.
This economic volatility was reflected in asset markets. Both global equities and fixed income produced negative returns over the year. UK-based investors, with global multi-asset portfolios, were insulated from the worst of the asset price falls due to the fall in the value of the British pound against other major currencies. This boosted the value of overseas holdings in sterling terms as well as boosting the profits of those UK listed companies which have overseas operations.
So, what of the future?
There are some positives to be noted. Policy makers have broadly risen to the challenge of the energy and cost of living crises. China, too, has relaxed its zero-COVID policy which will stimulate economic growth once the intense wave of coronavirus related infections clears. Furthermore, and perhaps most importantly, investors have started to expect a more pessimistic outlook; believing that developed economies will enter a mild recession this year.
As the consensus view nearly always turns out to be wrong, it’s worth considering the alternative outcomes. Put simply, will global economic growth surprise to the upside or downside relative to that already priced into markets?
The positive case around economic growth centres around Chinese economic growth pulling the rest of the world up at a time when headline inflation in the West falls faster than expected (due to lower energy and food prices as well as some goods price deflation as excess stocks are cleared and supply chains normalise).
The opposing scenario centres around a much deeper and longer recession which demands further cuts to company profits and rising corporate debt defaults. This would lead to further downside in equity and ‘riskier’ corporate debt prices.
How could this come about?
Developed market central banks have increased interest rates at a pace not seen in decades, such that the cost of paying debts for consumers, mortgage holders, corporates and governments will rise significantly. If these higher interest rates persist for longer than expected or, indeed, are increased by more than currently expected, higher unemployment is likely to be the result and consumer confidence would be further undermined. Housing market activity would also be pressurised further. As investors rebase expectations downwards, share prices would continue to be pressurised and the negative wealth effect (from lower asset prices) would also have an influence on consumer spending.
If this latter scenario pans out, core inflation is likely to fall more sharply than currently anticipated and wage inflation pressures would dissipate swiftly as unemployment takes a significant turn for the worse.
Either scenario is feasible and we continue to watch for early signs that support the more positive scenario, however, we remain concerned that the latter scenario is distinctly feasible given the risk that central banks fail to adjust monetary policy swiftly enough to engineer a soft landing.