Cheaper energy eases inflation – but a recession might still be required

Since the start of the year, equity markets have fluctuated while central banks have continued to raise interest rates to combat inflation. William Morris CFA, Head of Investments at Weatherbys Private Bank, discussed with Paul Dales, Chief UK Economist at Capital Economics, whether policymakers are winning the battle.

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How has news on inflation affected financial markets?

At the start of the year, inflationary pressures were fading quite fast and there was a growing expectation that central banks wouldn’t have to raise interest rates much further. The prospects were that they could actually start to look at cutting rates.

But as time went on, inflation proved to be stickier than anticipated. Central banks concluded that they would have to keep rates higher for longer, which weighed on markets.

This time last year energy prices were spiking amid the Ukraine conflict. Where are we now?

We’re in a much better place now. The winter was much milder than expected and that has contributed to a sharp fall in energy prices, which are back to mid-2021 levels.

In the UK, natural gas prices have plunged over 600 pence to just 100 pence per therm, and the oil price has fallen from US$130 a barrel to US$85 a barrel. It’s a real game-changer for the UK and eurozone as they import a lot of energy.

Can central banks declare victory over inflation?

It’s too soon, although the battle is going in their favour. Several factors are supporting continued inflation besides energy prices. But there are other domestic factors involved, and it may prove harder to get down to the Bank of England’s 2 per cent target level.

What are these domestic drivers of inflation? What keeps you up at night?

The resilience of the economies and the decline in energy prices put more money in people’s pockets. So that supports the real economy. There is also a very strong labour market and wage growth – these are inflation drivers that tend to last longer and are more of a slow burn.

What needs to change to hit the 2 per cent inflation target?

A big increase in the economy’s supply side, such as a boost in investment or productivity, will bring inflation down, or perhaps a sizeable increase in the number of people available to work. This would ease wage growth because businesses will not need to pay high wages to retain employees and attract new workers.

If you can’t get supply up to reduce inflation pressures, you’ve got to get demand down. I think this is more likely, because I don’t think we’re going to get this big burst of supply that suddenly brings wage growth and inflation back down. That’s why I believe we need a period of weak economic activity to get inflation back down to 2 per cent.

Have central banks raised rates enough?

That is the $64,000 question. My sense is that they probably have just done enough. But what’s important is that the full impact on economic activity from these rate hikes has not been felt yet.

As the effects filter through, it will trigger recessions in the UK, the eurozone and the US. It is those recessions, which will be small and mild by historical standards, that will help get inflation back down to the 2 per cent target.

There were some gloomy forecasts about the UK economy in the news recently. Do you agree with that view?

The IMF has forecast that the UK will fall into recession this year and be the worst performing G7 economy next year. I would agree with this sentiment, but I wouldn’t characterise that as being unique to the UK. I would group the UK together with the eurozone and the US. And this should be seen in the context of growth in previous years.

It’s worth reiterating that I still think a mild recession is a relatively favourable result. If we can get inflation back down to 2 per cent without interest rates going much higher, then that is a good result for financial markets. And if that does happen, recessions will be fading by the end of the year, inflation will be on the way back down to 2 per cent and central banks will be thinking about cutting interest rates.

What do you expect will happen over the coming months and the rest of the year?

The real focus is to what extent this economic weakness emerges. And if it does emerge, is that enough to get inflation back down to the 2 per cent target? The worry would be if inflation gets stuck at something like 4 per cent, as the onus will fall back on central banks to act.

If they conclude that the rate hikes made so far aren’t enough to slow the economy, then they may raise rates further or keep them higher for longer. But I think they will pause for now to see how the recent hikes play out.

How has the pound performed?

The pound has had a really good start to the year and is the best performing developed market currency. Unfortunately, I don’t think that will last.

A lot of the pound’s strength has been due to the weakness of the US dollar. Financial markets have concluded that interest rates in the US aren’t going to rise much further. Subsequently, there hasn’t been safe-haven demand for the US dollar.

If the US goes into recession over the next six to twelve months, that will change, and there’ll be a surge back towards the US dollar as investors seek safer assets. That will hurt the pound.

The Weatherbys view

While there is undoubtedly value in staying abreast of the latest economic developments, we would caution against leaning too heavily on one particular data point or forecast.

According to the latest Standard & Poor’s Index Versus Active (SPIVA) report, active investment managers in the UK had an annus horribilis in 2022 – 92 per cent failed to outperform their index. This underlines our view that it’s just not worth trying to fine-tune a portfolio to an excessive degree by attempting to pick out particular sectors or themes – these ideas are usually already well known and in the price.

Our position, which is borne out by that report, is to keep portfolios as robustly boring as possible, and instead expend our effort on our clients’ financial plans. That’s where we put all of our talent and expertise, and that is proving the right way to go.

Important information
Capital Economics is an independent consultancy firm. Past performance is not a guide to future returns. Please note that the value of investments can go down as well as up, and you may get back less than you originally invested.