There is an increasingly big gap appearing between official economic forecasts (the consensus is for a soft landing) and market expectations (inverted yield curves, higher market volatility, and falling risk assets) that are beginning to discount a greater probability of a steeper economic contraction. A few points to bear in mind:
- There cannot be a definitive and consistent response that covers all economic regions.
- There are considerable downside risks to growth from geopolitical forces (Ukraine/Russia, China/Taiwan,) that are difficult to quantify.
- Judgments must be made in terms of monetary and fiscal policies. We have adopted the traditional method of keeping interest rates steady at their peak for a 12-month period before edging them lower in subsequent years.
Our analysis of the underlying risks for consumers and corporates that underpin the economic projections is highlighted below.
- Consumer and corporate sentiment are deteriorating across the board, with contractionary signals in the UK.
- Real income is contracting across the board apart from Japan due to high inflation prints.
- Nominal income growth is rising. 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.
- For consumers, job growth remains supportive 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.
- Housing costs are rising across the board, and in some regions, such as Canada, a contraction is underway with a sharp fall in prices.
- 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 improved markedly for companies with the key Fed index reverting towards normality. The upcoming earnings season will provide further insight.
- Energy security is 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 still 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.
As we continue to monitor these key variables, they will feed our economic projections. If there is a shift into red for more data points, it will raise the risk of a harder landing. Such an outcome is more likely for the Euro Zone economy, with the UK economy also on the brink as it is battered by huge uncertainty and volatility following the recent fiscal event.
To find more about the latest house views from London & Capital’s Investment Desk, read the full AndPapers Q4 2022 here.