The Fed is raising interest rates to engineer a US recession
Recession for the world economy remains our base case. This recession will be the direct and intended consequence of US interest rates hikes.
Persistent sources of inflation in the US, outside energy costs, mean that the Federal Reserve will have to keep raising rates until they engineer a US recession. This will deliver the rise in unemployment required to slacken demand and allow inflation to fall back to target levels.
However, with flexible labour markets and few signs of the sort of imbalances that triggered the global financial crisis, this recession in 2023 should be neither deep nor long-lasting. Indeed, all going well, we should be able to anticipate an economic recovery well before the end of that year.
Growth forecasts tumble - Consensus growth forecasts for Q2 2023 GDP growth
The gas price crisis means a European recession
Europe is also headed for a recession. This is a direct consequence of the energy crisis triggered by the Russian invasion of the Ukraine.
The squeeze on the economy from the energy crisis will stifle other sources of inflation. Therefore, once we are through the worse of the winter, we can expect that European economies will be able to begin the process of recovery.
The uncertainties should not be underestimated. Coalition governments will need to make hard decisions on energy subsidies. A warm and windy winter would make a significant difference, as opposed to one where the wind-turbines don’t turn and temperatures plunge.
Inflation in US, EZ and UK: similar headline, very different food and energy - Consumer price inflation % year on year
Europe is heavily exposed to gas
Government action has transformed not removed the UK’s recession risks
A lack of judgement from the UK government has caused a market crisis. That is not irreparable given the strengths of the UK financial markets. Indeed, the government’s missteps may now leave the Bank of England with greater freedom to act.
The previous UK outlook was similar to the rest of Europe, an energy price driven crisis that would see inflation squeezed out by the accompanying recession. The government’s announcement of fuel price subsidies and tax cuts should avert the worse of the consumer squeeze and imminent recession.
That leaves the Bank of England in the role of the Fed, raising interest rates to squeeze out inflation. Imported inflation from weak sterling compounds the problem. The recession risk has therefore been postponed and transformed rather than cancelled. Higher mortgage rates should quickly hit the housing market, even if fixed-rate mortgages delay the impact for many households. There is a path where the UK escapes recession, but it is a narrow one.
Energy Bills
Source: Columbia Threadneedle Investments and Forefront as at September 2022
Too early to turn positive on investments before recession has even hit.
The outlook for equities remains negative. We believe that it is too early for investors to be looking forward to a recovery in 2023. While markets are clearly discounting inflationary and recessionary outlooks, we should recognise that the reality always plays out differently from the anticipated experience. A short recession is only apparent in hindsight.
We should also note the risk of policy mistakes, as we have seen in the UK. These can transform a tough economic situation into a crisis in financial markets. We remain happy to be long-term investors across the economic and market cycles. However, we recognise that until we see the recession unfold and markets react to the reality, we cannot make a call on a turning point for markets.
Relative value is still apparent. A strong US dollar reflects the reality of the US economy and higher interest rates. The UK equity market with its heavy weightings to multi-nationals and defensive sectors appears undervalued. While yields may have further to rise for bond markets, they are clearly offering much more attractive returns for cash investors that literally a week before.
Analysts’ earnings growth forecasts have fallen… and are set to fall further
