2022 saw much of the received wisdom concerning the investment norms of the past twenty plus years turned on its head.
Inflation reached double digits as COVID related pent up demand in the West met the reality of COVID related supply chain disruption in the East which was then made worse by the war in Ukraine which stimulated both an energy crisis (which the Organization of the Petroleum Exporting Countries (OPEC) chose not to ameliorate) 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 and quasi-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?
In some respects, there are 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. Furthermore, and perhaps most importantly, investors started to price in 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 earnings forecasts 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 borrowing for consumers, mortgage holders, corporates and governments will rise significantly as existing debt is refinanced. Highly indebted, privately financed companies are at particular risk. If these higher interest rates persist for longer than expected or, indeed, are increased by more than currently priced in, higher unemployment is likely to be the result and consumer confidence would be further undermined. Housing market activity would also be pressurised further. This would reduce end demand which would exacerbate the coming destocking cycle and put additional strain on employment. Operating margins which are high relative to history would fall, driving meaningful earnings downgrades. 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 end demand.
If this latter scenario pans out, core inflation is likely to fall more sharply than currently anticipated and wage inflation pressures will dissipate swiftly as unemployment takes a significant turn for the worse. Government bond prices would be supported, however the spread between the price companies pay for debt versus the government would widen as a result of a rising number of company credit rating downgrades and, for riskier companies, defaults.