What has caused the optimistic mood?
There have been three key drivers. First, there are signs that we are winning the battle against inflation. Second, economic indicators suggest Europe and the UK could be more resilient to the headwinds that they faced last year. And third, China’s economy has rebounded vigorously since it ended its zero-Covid policy in December.
Why aren’t we in a recession yet?
There were widespread expectations that the European and UK economies would fall into recession last year. But that hasn’t happened – their economies have been weak, but they have not fallen into a deep contraction. There has been more resilience, perhaps because governments have absorbed the hit by helping households or businesses more, or because households have still got some savings left over that they built up during the pandemic. Plus, businesses may have some cash left over from Covid bounce-back loans. That said, while Europe’s and the UK’s economies are doing better than expected, it looks as though the US is slipping into a recession.
What is happening with inflation?
Thankfully, it is starting to subside, particularly in the US where inflation is well past its peak. That’s thanks to recent falls in commodity prices, shipping rates and an easing of supply shortages. Inflation has likely peaked in the UK and Europe too, but there is less reason to celebrate, because the key difference is that, unlike in the US, there are no signs that domestic inflation has eased. The path of inflation in the UK and Europe has lagged behind the US by around three to six months – we think this will continue to be the case.
Do you think we are over the worst?
There are three reasons to be cautious. First, while inflation has come down, we can’t declare victory just yet. Second, the drag on economic activity from higher interest rates has not been felt in full. Third, while we’ve become more optimistic about the outlook for China over the near term, there are still reasons to be concerned over a five- to ten-year period. There are reasons for optimism right now, but I just wonder if people are getting a little carried away.
What are your forecasts for inflation?
The hope, and the expectation, is that inflation magically falls back to 2 per cent, which is the target that most central banks aim for, and for everything to return to normal. But there is a risk that it doesn’t, or that it falls but gets stuck at let’s say 4 per cent. If that happens, central banks may have to either raise interest rates, or hold off from cutting them. These risks are higher for the UK, where job shortages are greater and there’s more upwards pressure on wage growth, which means inflation might be less inclined to fall to 2 per cent.
How high will interest rates go?
We are forecasting the Bank of England to raise interest rates from 4 per cent to 4.5 per cent this year. However, we think the US Federal Reserve will be in a position to cut interest rates before the end of the year – if, as we expect, inflation continues to fall.
Why hasn’t the effect of higher interest rates in the UK been felt in full?
More households have fixed-rate mortgages than variable-rate mortgages. So, higher interest rates feed through into the economy at a slower rate. There will be lots of people on fixed-rate mortgages in the UK who won’t have been affected by last year’s rate increases. They won’t be affected until their fixed rate expires, which for some people might be soon, but for others might still be some months down the line. It is only when that happens that you get the full effect of higher interest rates, which is why it is too soon to declare that everything’s great – we know this hit is coming.
What is your outlook for the global economy?
I believe that some of the economic pain is yet to come, and I suspect that the US, UK and eurozone economies will all fall into recessions this year. These recessions may not be as deep as looked likely last year, which is a reason for optimism, but I still don’t think we are going to get away scot-free. There is a brighter path ahead in the second half of the year, but I am certainly cautious about the next six months.
What is your expectation for financial markets?
We are anticipating equity prices in the US, Europe and the UK to fall back at some point over the next six months. We expect the euro to weaken and the pound to fall too. But it’s important to note that these are short-term effects. If our forecasts are right, then by around the middle of the year recessions will be underway but we’ll be able to see light at the end of the tunnel. We expect inflation to be falling back and to see interest rate cuts on the horizon. There could be a genuine improvement in the economic outlook during the second half of the year, which financial markets can feed off.
The Weatherbys view
At Weatherbys we believe it is important to stay abreast of economic developments, but not to make plans entirely dependent on forecasts. Instead, we build investment portfolios that are all-weather affairs, designed to perform solidly whatever happens – rather than going all-in on a particular expectation of what the future holds.
Our position is that you are much better off putting a bit of thought into financial planning and taking broad advice where it is needed on matters of income, retirement and your broader estate – not needlessly fine-tuning a portfolio and twitching on market news.
As ever, we remain at your disposal to solve whatever financial quandaries may be weighing on your mind.
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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.