In the UK, the government’s fiscal event on 23 September swiftly morphed into a significant monetary event as the credibility of the new spending 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 centric asset classes. Following criticism from the International Monetary Fund (IMF) and rating agencies, amongst others, the sell off continued and with increasing margin calls on pension funds’ liability driven investments, the Bank of England was forced to announce a bond buying program to settle nerves on 28 September.
At time of writing this has had the desired effect. The future messaging concerning medium term spending by both Truss and Kwarteng will be closely followed. These politicians now find themselves in a trap of their own making. They have three options: 1. cut public spending; 2. produce a more substantial u-turn on tax cuts; or 3. double down on their rhetoric and do nothing to assuage market concerns. The role of the Office of Budget Responsibility in assessing spending plans is important and the pair also need the support of parliament in order to act. It would now appear that the Prime Minister and Chancellor are beginning to understand these constraints on their policy making decisions.
Given the mess, it is fair to assume that the risk free discount rate for UK investments has increased. Despite this, the market falls have 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. Indeed, the retrenchment could be fairly swift during 2023 as falling energy prices and slowing food price rises counter the price spike witnessed during the first half of 2022. 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 in order to ameliorate the current environment of negative real wage growth. This will show up most obviously in the service sector inflation numbers. Mitigation, to some extent, will be provided by a reduction in goods inflation as supply chains normalise and companies look to clear high inventories. 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 related (release from lockdown) boom in demand. We anticipate that consensus earnings forecasts for 2023 and 2024, which have remained resilient, will be revised down.
This means that during 2023 investors are likely to feel the impact of both 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 higher 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 amplifies slowdowns. This time round the tightening of lending standards should be far less dramatic than those observed 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 a Federal Reserve policy switch from increasing to reducing interest rates. When this happens, equities are likely to perform strongly and will likely lead a recovery in investment values.