The gap between official economic forecasts (the consensus is for a soft landing) and market expectations has widened further, with the latter discounting a greater probability of a steeper economic contraction.
In our economic projections that underpin our asset allocation, there are a few overarching comments that must be kept in mind.
- First, we maintain our view, developed over the past couple of quarters, that there cannot be a consistent response that covers all economic regions.
- Second, judgments have to be made in terms of monetary and fiscal policies. We have adopted the traditional method of factoring in market implied interest rates for 2023 before edging them lower in subsequent years. These rate expectations can move, but it is unlikely that there can be an upward shift as large as what we saw in 2022 as central banks rapidly ratcheted up interest rates. However, a downward adjustment may well appear. On the fiscal front, there is some clarity for the major economies.
- Finally, there are still downside risks to growth from geopolitical forces (Ukraine/Russia, China/Taiwan, and OPEC to name a few) that are difficult to quantify.
Our analysis of the underlying risks for consumers and corporates that underpin the economic projections is highlighted below.
LCAM’s base scenario is for a technical recession across a number of major developed economies before reverting to below potential growth rates in 2024. This could be labelled a “soft landing,” but it is apparent that the risk of a policy mistake leading to a deeper recession is high right now.
Overall growth forecasts have been revised lower across the board for 2023, with Canada, the UK, and the Eurozone most at risk of a deeper recession.
- Consumer and corporate sentiment have been weak, with contractionary signals in the UK. In the US and EZ, the pace of contraction may be easing, but this may be in response to lower energy costs rather than higher underlying demand.
- Real income is contracting across the board due to high inflation, but pressures will ease through the course of this year as inflation moves lower.
- Nominal income growth is rising, but it is insufficient to prevent the squeeze on consumer real income growth. Higher wage costs will be a source of concern for companies, as with weakening demand, the scope for maintaining margin growth will be more difficult.
- A recent FT article featured the importance to the Fed of potential lower corporate margins as a means of taming inflation. This is a view we have sympathy with, as companies may well find it difficult to pass on higher prices to consumers as demand weakens.
- Job growth remains supportive for consumers for the time being, with lower participation rates and plentiful job openings. It is normal for the labour market to correct late in the cycle, and it may well be that COVID has led to a structural shift in the supply of labour and hoarding of labour that could take time to unwind.
- Housing costs are rising across the board, and in some regions, such as Canada and the UK, a contraction is underway.
- Although companies are facing higher costs of funding, they are entering this recession with lower refinancing risks, higher cash balances, and manageable leverage.
- Supply-side pressures have continued to improve markedly for companies, with the key Fed index reverting towards normality. Port delays and freight costs have also improved.
- Energy security could continue to be a significant problem for the Eurozone and the UK, with no quick end in sight to the disruption in supply from Russia/Ukraine. Although both oil and natural gas prices have declined from peak levels, they could yet be disruptive. The US and Canada are shielded from the direct impact of higher energy insecurity, but will be indirectly exposed to slowing global economic activity.
To find more about the latest house views from London & Capital’s Investment Desk, read the full AndPapers Q1 2023 here.