Spring economic update, April 2022
Key points:
- Inflation expected to remain above 6 per cent in 2022
- UK economic growth slow but there won’t be a recession
- Real incomes to fall by 2 per cent – the sharpest decline since records began in 1950
- Interest rates to rise above 3 per cent as central banks seek to tame rising prices
- Equities the best-placed asset class to preserve real value
How do you sum up the first quarter of 2022?
It’s been a rollercoaster. At one point, UK equity prices were down by 7 per cent and US equity prices by 14 per cent, while sterling suffered its biggest daily decline since March 2020.
Some of these big moves have since reversed, but the lasting legacy has been rising commodity prices. Oil prices are still 40 per cent higher and wholesale gas prices 30 per cent higher than they were at the start of the year.
What is going to happen to inflation?
In a word, ‘up’. Even before the war in Ukraine, inflation in the UK (on the CPI measure) was at a 30-year high of 6.2 per cent – three times higher than the Bank of England’s 2 per cent inflation target.
Before the Ukraine crisis, we had forecast that inflation would rise to above 8 per cent in April, before falling back to around 2 per cent by the end of the year. We now believe it will peak at 8.3 per cent in April this year and remain above 6 per cent throughout 2022 – and we expect inflation to be above 3 per cent for most of 2023.
What can central banks do?
When inflation is rising and economic growth is strong, central banks typically raise interest rates. On the other hand, when inflation is low and economic growth is weak, they tend to cut interest rates. Unfortunately, right now inflation is high and growth is anaemic, so central banks are between a rock and a hard place.
However, with labour markets strong (which isn’t a feature of stagflation), we think that this raises the prospect of central banks raising interest rates, which could, in turn, take some of the heat out of the economy, resulting in falling inflation.
We believe raising rates to 2 per cent could be the answer, but if prices and wages keep rising then central banks will have to work a bit harder to control inflation. That is when interest rates could rise to 3 or 3.5 per cent, which is still not high by historical standards.
What is happening to real incomes in the UK?
Households’ real incomes have declined, and this is going to be the big story of the year. We are forecasting that real disposable incomes will fall by about 2 per cent this year, which would be the biggest fall since records began in the 1950s. The cost-of-living crisis is real and will underpin the economic trends this year.
What will be the knock-on effects on economic growth?
Economic growth will fall, but importantly we are not expecting a recession. We believe that households are going to be in a position where they can offset or cushion the blow to their real incomes by saving less or dipping into their savings.
If that is the case, that will smooth spending patterns and keep the economy growing rather than falling into a recession. However, we have revised our GDP growth forecast downwards for next year from 3 per cent to 2 per cent.
Weatherbys’ view: William Morris CFA, Head of Investments
The key for me in my role as Head of Investments is to assess whether anything has changed from the fundamental case to invest in equities for the long term, despite the inflationary headwinds.
We have to be very careful of projecting the recent past into the future too much. As we all know, forecasts are best guesses, and the worst thing we can do is to pretend we know with 100 per cent certainty that what has happened in the past three months is going to prevail for the next 10 years. I would be very leery of that notion.
It is plausible that investors will not earn the same levels of returns over the next five years that they may have generated over the past decade. However, it’s highly questionable whether any other major asset class is going to be able to outpace inflation the way equity investments have historically done.
What does it mean for Weatherbys Private Bank clients?
At Weatherbys we build portfolios that are designed to achieve the long-term objectives of our clients. We keep them as straightforward and efficient as possible.
We engineer our portfolios to be cognisant of changing economic and market conditions. For example, we factor in rising interest rates when solving for the proportions to invest in various types of fixed income assets, depending on their ability to plausibly dilute stock market crashes.
But even before we tweak portfolios, we can be adaptive in the way we provide financial planning advice. For several months now we have been using an assumption of elevated inflation in our cash flow models. This enables our clients to see what that scenario would mean for them and to give us the chance to recommend changes to their lifetime financial strategy if appropriate.
The overriding message is to be circumspect of anyone claiming to have an inflation-busting ‘silver bullet’. Most likely you will be best served by staying invested in a diversified portfolio that leans as far into equities as your financial strategy suggests is prudent.
Above all, higher inflation is a prompt to check if your wealth is positioned appropriately for your circumstances and objectives, or whether things need a shake-up.
If you want to discuss how inflation may affect you, please get in touch using the form below to find out how we can help you.
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.