Very quickly, the mood this year has shifted from post-Covid optimism to war-induced worries around double-digit inflation and fears of a return to the dark days of recession.
Aside from political noise, Chief Economist Phil Shaw explained there are four major themes dominating the agenda: inflation, interest rates, recession fears and geopolitical uncertainty.
Giving his assessment of the economy midway through the year, he clearly said that while things may look dire, we will not have a repeat of 2008. Rather, we are seeing temporary disruptions that should die down over the course of the next year. He reminded us the banking system is much more robust than before the global financial crisis and central banks should easily be able to deal with the cyclical downturn.
After years of disinflation, low rates and mammoth quantitative easing programmes, compounded by shifts in demand caused by Covid-19, Shaw said the return of inflation was understandable. Supply disruptions have also played a major role, with shortages exacerbated by the war in Ukraine, especially in the energy market. Shaw remarked labour forces have also shrunk, particularly in the US and UK, where there are 400,000 less people employed than prior to the pandemic.
Yet the strength and duration of inflation caught many by surprise. Now, Shaw and his team expect the UK Consumer Price Index, which stands at a record 9.1%, to surpass 11%. With wholesale gas prices continuing to rise, they foresee another 57-60% increase in the energy price cap in October.
After the autumn, Shaw said they expect inflation to slow sharply as the price of energy and other goods such as second-hand cars might start to decline, falling once again below 2% by the fourth quarter of 2023. However, Shaw caveated this depends on the material reversal of energy prices and on wage growth remaining subdued. If salaries rise to match inflation, this could cause a wage-price spiral.
Sterling could be another factor maintaining higher levels of inflation, with the currency currently suffering against the dollar. Even in the worst case scenario, however, if wages rise to meet inflation, Shaw said he would be surprised if there is more than one bout of double-digit inflation in the coming year.
Globally, inflationary forces are exacerbated by geopolitical uncertainty. The strength of oil prices and concerns Russia could cut off energy supplies over the winter, coupled with the current Norwegian gas workers’ strike, make for a worrying energy outlook. Meanwhile, shortages of key materials, including wheat, potash and semiconductors, due to the ongoing conflict in Ukraine and Covid-19 lockdowns in China are continuing to disrupt supply chains.
Temporary rate rises
With rising costs, another issue weighing on the minds of borrowers is how interest rates will be affected. As the Economics team explains in its latest Global Economic Overview, there has been a step change from central banks, which have all become more hawkish – signalling their intent to keep raising rates higher to curb inflation.
But Shaw raised an interesting question. If, like them, central banks believe inflation will fall back later this year, why are they stepping up the pace of monetary tightening? He explained rates have been ultra low for a long time, and there is a sense banks have some catching up to do. There is also uncertainty over how much inflation will come down next year. Labour market tightness and the potential for a wage-price spiral are also playing on policymakers’ minds.
Faced with a double whammy of rising costs and higher rates, as well as recent tax increases, households will struggle, said Shaw, predicting a decline of 1.5% in post-tax income this year. As a result, he expects the UK economy to contract for two successive months, which is technically considered a recession. However, Shaw emphasised this would be a short and mild spell.
The silver lining, said Shaw, would be that rates may not have to climb as high as markets expect. If consumer spending slows, central banks will likely be prompted to lower rates once more to enable an economic recovery – 2023 might see them return to 1.25% in the UK and 2.25-2.50% in the US.
Security comes to the fore
The current economic and geopolitical situation will not only affect individuals, it has wide implications for different industries. Ben Bourne, Head of Capital Goods and Alternative Energy Research at Investec, broke down the impact on defence, new energy and industrials.
Increasingly shunned by governments and investors alike, the defence sector has suddenly seen a material reversal of fortune. While the US has to date been the heaviest defence spender, Germany’s commitment of €100 billion – which had to go through an amendment of the constitution – represents a watershed moment, Bourne noted.
Additionally, he said the accession of historically neutral Sweden and Finland to the North Atlantic Treaty Organization (NATO) is of enormous significance, with the alliance bolstering its military readiness by more than sevenfold in Europe.
While only one third of members last year met the group’s 2% of GDP target for military spending, Bourne said there has been a fundamental shift in thinking, with signatories now increasing defence budgets. Not only are European countries recapitalising the stock that has been sent to Ukraine, he said they are developing their continental forces and investing additional resources into modernising ageing combat vehicles and increasing their cybersecurity and electronic warfare arsenal.
Bourne added that ESG investment mandates, which take environmental, social and governance factors into consideration, are gradually changing as a result of the war in Ukraine. “This is to embrace a sector previously deemed abhorrent; this is a realisation that the duty of any government is to ensure the protection of its citizens. […] It is a net positive for the industry, where increasing numbers of European investors are seeing defence as important to ensuring a sustainable society.”
Meanwhile, he said the US, which was already the leviathan defence spender, is more removed from the situation: “In the US, many believe that Russia is a storm but China is really the equivalent of global warming – and they’re preparing themselves for that.”
The new energy imperative
The Ukraine war is also accelerating shifts that were already underway in the energy sector, explained Bourne. Adding to widespread net-zero commitments from governments and corporates, he said: “There is nothing like the risk of a very cold winter with potential rationing to sharpen the minds of industry and investors.”
The EU, which accounted for 61% of Russian fossil fuel exports during the first 100 post-invasion days, will have to explore clean energy alternatives, said Bourne. The group has now implemented a sixth package of sanctions against Russia that includes a ban on seaborne crude and petroleum product imports. So far, renewables including wind and solar account for 10-15% of generation in Eastern Europe and 20-30% in Western Europe, but more is coming, according to Bourne.
He pointed to green hydrogen as one of the technologies to watch. Predicted to make up 18% of primary energy generation globally by 2050, and amounting to $2.5trn of market opportunity, Bourne said the use cases are huge, particularly for decarbonising hard-to-abate industrial areas and balancing the intermittency of renewable energy.
However, Bourne noted there are considerable challenges to making and storing hydrogen, which may delay uptake. He noted the current period of eye watering inflation, as well as supply chain disruptions and elevated materials prices, have somewhat halted the momentum behind green energy. But if Phil Shaw’s predictions of an inflation slowdown materialise, Bourne said the stability will allow policymakers to concentrate on bolstering the industry.
Industrials on offer
Industrials, meanwhile, have been negatively impacted by geopolitical developments – but this could present a buying opportunity for investors, said Bourne.
He explained inflation has been underestimated in this sector, and supply constraints resulting from the war in Ukraine have been acute – in titanium, palladium and high grade neon. Stock prices have fallen as a result, and Bourne said: “The importance of owning price makers instead of takers in your portfolio is absolutely paramount.”
However, investors are turning their attention to the next super-cycle, where firms are expected to deploy capex on reshoring and leaders may look to consolidate their positions through acquisitions. He said many investors consider UK industrials to be takeover candidates, given the weakness of sterling. In addition, he said the UK contains many world class leaders in niche subsectors that have proven themselves over time and have global manufacturing footprints.
He said: “US and increasingly European investors are waiting for pain in Q4. The lead indicators certainly signal a tricky Q4 – a reduction in demand, destocking, recession. They are looking to that period as the point of maximum pain in order to increase their weighting to UK industrials, given the relative value offered in the UK market.