Kevin Boscher, chief investment officer at Ravenscroft, takes a macro view of current economic conditions in markets around the world, and looks at what the outlook is for growth after a volatile post-pandemic period
The global economic and market environment is in a volatile transition from an inflationary boom to a period of disinflation and weakening activity.
Investors have been fearing and expecting a US recession for some time and similarly in the UK and Europe.
Indeed, markets started to price in a peak in US interest rates and a Federal Reserve System pivot some months ago around the time when problems in the US banking sector first started to emerge.
Although there are clear signs that US and European economic activity is softening and a recession looks likely, there are sound reasons why growth has so far held up better than expected and despite a significant tightening of monetary conditions.
One of the key reasons is that the US, UK and European consumers, which account for roughly two-thirds of economic activity, have been able to continue spending through a period of rising prices thanks to a strong employment market, some wage growth and unusually high pent-up savings as a result of the huge pandemic-related monetary and fiscal easing.
Growth has also been supported by a relatively mild winter, which has enabled energy prices to fall materially, the reopening of China as well as reasonably strong housing and stock markets.
Recent economic data confirms that US (and European) activity is falling quite rapidly and that employment pressures are starting to ease as an increasing number of companies lay off workers and wage growth moderates.
Together with evidence that consumers have largely drawn down on their pandemic-bloated savings and rents are turning lower, this should accelerate the disinflationary process and provide the Federal Reserve System with the catalyst it needs to turn more dovish.
In addition, a banking crisis is inherently disinflationary as banks are forced to shrink their loan books and reduce their balance sheets to improve their liquidity and protect their solvency.
This hurts businesses, dampens consumer spending and squeezes corporate investment, thus leading to a credit crunch and slower growth.
Although some stability has returned to the banking sector, the problems are far from over with regional banks still haemorrhaging deposits, and are likely a strong sign that the Fed has already done enough with much of the lagged impact of rate hikes yet to come through.
Historically, the Federal Reserve System has always eased quickly and aggressively whenever faced with a banking crisis to counter deflationary pressures and limit financial contagion.
This time around, inflationary pressures have forced the Federal Reserve System to separate their roles of ensuring enough liquidity in the system while also tackling inflation, but as recession hits and disinflation accelerates, the Federal Reserve System will likely be persuaded to act.
The pending Debt Ceiling debate could also put pressure on the Federal Reserve System since any increase in market volatility around a delayed decision or subsequent increase in Treasury issuance and borrowing post a decision will exacerbate the recession risk.
Markets currently expect the Bank of England and European Central Bank to modestly raise rates further over the coming months and to hold them there for some time, thus leading to a divergence of monetary policy from the US.
It’s certainly true that inflation appears to be much stickier in both regions. In the case of the UK, a structurally tight labour market in the aftermath of both Brexit and Covid-19 is putting upward pressure on wages and prices while the weakness of Sterling (until recently) and a propensity to import most of the country’s food and energy needs are also contributory factors.
In the case of Europe, a strong labour market and pent-up savings are also part of the explanation but, in addition, the European Central Bank was late in starting to raise rates.
Similarly to the US, it is clear that growth is slowing materially and it is unlikely either the UK or Europe can escape recession over the next few quarters as consumers cut back, unemployment picks up, investment slows and the US recession bites.
Beyond the next year or so, we are very conscious that the post-pandemic world appears to be changing in a number of ways which will likely have a huge influence on the global economy and markets over the next decade or longer.
Some of the key factors that are shaping our thoughts include the ageing demographic and shrinking workforces, income and wealth inequality, increasing geopolitical angst resulting in a fragmenting world and climate change.
Nobody knows how these will evolve and interact and what it means for the macro environment and markets but it will most likely lead to a prolonged period of elevated economic, market and inflation volatility.
It will also present serious challenges for central banks and governments everywhere. However, it’s certainly not all doom and gloom and lots of new and exciting investment opportunities will arise as events unfold.
It is also likely that a different investment strategy will be required to deliver superior investment returns to the one that has worked so well for the past decade or so.
Economic and political outlook
Markets like to climb the proverbial ‘wall of worry’ and always have plenty of reasons for concern.
The present time is no exception, but both bonds and equities have rallied over recent weeks in anticipation of a Federal Reserve System pause and the start of a new easing cycle.
Investors are also hoping that any recession will be relatively mild and short in duration thanks to the robust employment backdrop and strong household balance sheets, together with falling inflation and an easier Fed.
We remain constructive on the outlook for stocks and bonds in absolute terms and the end of one of the most aggressive periods of Fed tightening ever should be unambiguously bullish for both bonds and stocks, especially if disinflation prevails, as expected.
Having said that, it is sensible to remain reasonably defensive and cautious for now, or at least until we get some more clarity around Federal Reserve System policy, banking problems, the Debt Ceiling debate, earnings outlook and inflation.
The global economic and political outlook is challenging and uncertain and nobody (including the Federal Reserve System, Bank of England and European Central Bank) can be certain where we are headed.
We have not been through a pandemic, followed by a war, energy crisis and inflation shock before, and economic models are unlikely to accurately predict the future.
It is possible to make a case why the Fed (and indeed Bank of England and European Central Bank) will soon be reversing policy and cutting rates, perhaps quite aggressively, while it is also feasible that the Federal Reserve System will maintain its hawkish stance and rates will move higher and stay there into 2024.
In addition, the world economy is going through a period of desynchronised activity with recessions likely in many developed economies, while China and other emerging economies are in recovery mode.
Similarly, inflation has peaked in the US and is falling quite rapidly whereas it remains sticky and slow to ease in the UK and Europe, while China and other parts of Asia are closer to deflation.
In such an environment, policy making is extremely difficult and we are likely to see a diverging approach here as well with the Federal Reserve System expected to cut rates, and China ease policy at the same time as the Bank of England and European Central Bank continue to move rates higher.
In our view, the most likely base case is that the next year or so will feel quite disinflationary as recession kicks in and we are at or close to peak rates in the US, UK and Europe, with rates starting to gradually fall either later this year or early next.
However, longer term, we are more likely returning to a period of elevated economic and inflation volatility as outlined above, although even here there is some doubt as the strong secular trends, which have put downward pressure on inflation and interest rates since the late 1980s, are still intact, as recently highlighted by the International Monetary Fund.
A logical conclusion from this is that cash will continue to be a high yielding and important asset class moving forward and will require careful and skilled management in order to navigate the choppy environment that lies ahead.
To find out more about Ravenscroft’s specialist captive investment proposition, read our full report, Captive Guide to Investments 2023.