This presents central banks with a dilemma: do they hold the course on interest rate rises and risk recession? Or make sure inflation is fully under control? Andrew Eve, investment specialist, fixed income at M&G Investments: “Because we’ve seen inflationary pressures for so long – and the Federal Reserve and other central banks were slow to act – they now find themselves in a difficult position. Monetary policy effects happen with a 6-12 month lag. Will they be able to engineer a soft landing and taper rate hikes in line with slowing growth and the peak in inflation?”
He says that while headline inflation has started to come down, core parts of inflation index remain elevated. The strong labour market in the US is a particular area of concern. However, Darling says the labour market is a lagging indicator of inflation and there are tentative signs of weakness. People coming back to work at same time as companies are becoming more cautious on hiring. Eve adds: “In the next year, we think they’ll start to taper increases as we see growth beginning to slow, but they’ll probably hold rates at an elevated level rather than reverse course.”
Beyond the Fed
While the Federal Reserve will set the tone for other markets, not all central banks will follow their lead. The US economy is stronger than most. Simon Prior, fund manager, fixed income team at Premier Miton Investors says: “A lot of central banks are on the same path, but whether they can get there without breaking their own economies remains to be seen. In the UK, rate rises are unlikely to be anywhere near the terminal rate in the US, but the Bank of England will try and get as close as it can.”
In the longer-term, inflation levels are likely to settle higher, but there are a couple of potential curve balls. Russia/Ukraine is a material factor in commodity markets. Any resolution is a long shot, but it would be an important factor if it happened. Equally, says Darling, China could be an important factor in global inflation.
“China has been in a deflationary lockdown – which has had a big impact on global trade, on global supply chains and commodity prices. As it tries to come out of Covid lockdown and revive its economy, that will have a big impact. My suspicion is that with the debt overhang in the global economy, plus demographic pressures, central banks don’t want to be too hawkish. While they are saying that they will get to a terminal interest rate and stay there for a sustained period to make sure inflation is contained, the world can’t sustain high real interest rates without causing lasting damage. They will be looking to retreat gracefully.”
The growth question
The consensus is for a significant slowdown in growth in the year ahead. Eve agrees: “Our core view is that we are likely to see a very mild recession in the US. The question is not whether we see a recession, but more ‘how bad will it be?’ The two big slowdowns in growth – 2008 and the Covid pandemic – have been quite severe. We don’t believe 2023 will be at those levels.”
The slowdown in the Eurozone, he says, is likely to be more severe with the added pressure of the energy crisis: “In emerging markets we see more cause for optimism, particularly as the US has reached peak interest rates.”
The UK is probably “over the worst” says Prior, but pressures remain. There is already some deflation in goods prices, but the labour market is still very strong and strikes are creating more wage pressure. “This makes it difficult for inflation to come back to 2%. The UK is a service-led economy, so wage rises do filter through.”
The gilt market may also struggle, with debt issuance increasing and quantitative tightening reducing demand. Prior says: “There was record issuance of £165bn after the financial crisis. This year and next it could be as high as £300bn. This is a lot for the market to digest. It’s still very difficult for interest rates to go back to our recent past and the UK gilt market may remain under pressure, just because of supply.” The resulting higher borrowing costs may be felt across the economy.
2023 will be a different year for inflation and interest rates after the severe adjustment in 2022. This creates a more stable backdrop for fixed income investors, even if pressures still remain.