Interest rates are expected to peak at just over 4% in the UK and just over 5% in the US in the first half of this year.
What are the prospects for economic growth and inflation in 2023?
2022 will be remembered as a year when inflation erupted again after years lying dormant. After rising relentlessly throughout the year, headline rates of inflation in the UK and Europe finally dipped in November. Although they remain high, we expect inflation to continue to subside in the months ahead.
But more important is where it settles in the medium term. What began as inflation in prices of energy and manufactured goods has now clearly spread to services and to wages in particular. Labour markets remain very tight, and wages are rising by more than 5% per annum in the US and 6% a year in the UK. This is the pressure point we’re watching most closely as absent improvements in productivity, this is what could sustain a wage price spiral.
Interest rates are expected to peak at just over 4% in the UK and just over 5% in the US in the first half of this year. Higher interest rates will take a toll on economic growth, but rising unemployment may be the most effective way to curb wage inflation. We therefore expect the focus of attention amongst investors to shift from inflation to economic growth in 2023.
There are clear risks to the consensus that any recessions will be mild, that inflation has been conquered and that interest rates will soon be on their way down.
What is the outlook for Bond markets?
2022 was truly a horror show for investors in bond markets. For more than a decade before investors had enjoyed outsized returns from bonds as central banks bought almost continuously, and this together with negligible interest rates, compressed bond yields to extremely low levels. The return with a vengeance of inflation has erased those past excess returns in the most brutal manner.
One of the worst parts of the bond market was the UK government guilts, which fell almost 24% across the year. This market has a very long repayment profile, which makes it especially sensitive to changes in yield. The big decision for investors now is whether they should be increasing their exposure to bonds. Yields are still significantly lower than where they averaged in the decade before quantitative easing began, and when inflation was also much lower than it is now.
Although some attractive opportunities are now emerging, for example, in high quality corporate bonds, we do not yet think that the case for increasing our overall exposure to bond markets is compelling.
What is the outlook for Equity markets?
Despite an impressive rally in the final quarter, global equity market indices ended the year down by just over 15% (in local currency terms), making 2022 the worst year for stock market since 2008. The US stock market, with its heavy weighting in highly valued technology companies fell by 19%. In contrast, the UK stock market, which is dominated by much more modestly valued oil companies, miners, banks and tobacco companies eked out a tiny gain, but only if all important dividends are included.
The decline in stock markets last year were predominantly due to rising interest rates and bond yields, which left share valuations looking overstretched and vulnerable. In general, corporate profits were fine. Despite 2022’s loss, global stock markets has still returned 167% over the last 10 years, which is some 10% per year, and serves as a reminder that they should be viewed as long-term investments.
In 2023, we expect corporate profits to become the main driver of share price performance, control of wage inflation will be critical in protecting profit margins, and companies with dominant market positions and strong balance sheets will be best placed to weather any forthcoming economic storm.
We continue to emphasise those characteristics in our fund selection in actively managed portfolio.
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The information within this article is for information purposes only and does not constitute investment advice. They represent the opinions of the fund manager and those of Square Mile. It does not contain all of the information which as an investor may require in order to make an investment decision. Any reference to shares/investments is not a recommendation to buy or sell. If you are unsure, you should seek professional independent financial advice.
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