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WRITTEN BY CHIEF ECONOMIST, MAARTEN ACKERMAN
This year has been tough. What’s more, a number of economic and geopolitical events have destabilised the global economy. So, when I ask, “Are we there yet?”, I am not referring to the end of 2022, but rather whether the global economy has reached peak inflation. This is the point where global central banks can pivot away from their hawkish views, adjust their rate hikes and slow down the pace of interest rate hikes we have seen in 2022.
Key themes for the year: Inflation and the mighty dollar
If you look back to our first edition of Peregrination this year, we examined some of the themes that we could expect in 2022. At number one was inflation, together with resulting central bank policy, illustrating that Peregrine Wealth was clearly prepared for what has transpired. Although these key themes were further escalated by the war, it is the speed and the magnitude at which central banks started to hike rates that has shaken the markets.
The other key theme at the moment is the dollar’s strength against its peers and emerging market currencies. The reason that this is so important in an investment environment is that it sucks liquidity out of the entire system. So, if you look back in time at the tech bubble, the housing bubble, the great financial crisis, and the sovereign debt crisis, although economies floundered, we did not have the same level of inflation that we are currently experiencing. Central banks were therefore able to step in and either lower interest rates or “print money” in the form of quantitative easing. This time, an economic crisis is developing with unsustainable levels of inflation, meaning governments will be able to do very little to help buoy economies.
The US leading global central bank complacency in the face of runaway inflation
This is the first time since the 1980s that the world has seen these levels of inflation. As such, the concern amongst the financial fraternity is that central banks have become complacent and are late out of the starting blocks. While they were slow to respond, when they did, they did so with great aggression. This has resulted in economists asking whether central banks are overreacting with the speed and level of rate hikes, and whether this will result in a much harsher landing than what has currently been priced into the markets.
United States (US) Federal Reserve (Fed) Chair, Jerome Powell, has stated that to reduce inflation, the banks are prepared to endure a period of below-trend growth. But while higher interest rates, slower growth, and a softer labour market will bring down inflation, they will also result in tough times for households and businesses. The big concern is, however, whether this current interest rate cycle is going to lead to a global recession and how serious that recession will be.
Central banks appear to understand that interest rate hikes will hurt economies, but when will they be comfortable enough to start slowing down those rate hikes? The argument is that the earlier they start doing so, the softer the landing will be, but many economists believe that they have gone too far already, and that the global economy might be heading for a tough recession. However, central banks are anxious, and want to convey the message that they are not going to allow a repeat of the mistakes of the 1970s.
On the back of these hikes the dollar is extremely strong. This year, the Japanese yen fell to 32-year lows against the dollar. The pound plummeted to a 37-year low against the dollar, triggered by the United Kingdom’s (UK) mini-budget and fiscal spending announcement. Government bond yields have also been repricing rapidly, pulling even more liquidity out of the system. This again shows how complacent the global economy became, as bond yields just moved lower and lower over the past few decades.
In the red – the Peregrine Wealth Recession Scorecard
At Peregrine Wealth we have a recession scorecard where we look at 10 fundamental factors. Again, referring to our first edition of Peregrination this year, you will remember that our scorecard predicted less than a 25% chance of the world moving into a recession. Now as we start the fourth quarter of 2022, this has rapidly deteriorated. The scorecard now indicates that there is more than a 90% likelihood that we will see a global recession in 2023, with only one of our indicators still green, and the rest having switched to yellow or red.
The current green indicator on our scorecard is the state of the US labour market. Recessions go hand-in-hand with rising unemployment, but the US economy is still in a state of full employment. This is good news.
However, as we enter the final quarter of the year, the US economy has already experienced two quarters of negative gross domestic product (GDP) growth, which is the textbook definition of a recession. Consumers are under pressure and household debt has increased significantly over the past few months. This reflects a cost-of-living crisis, which means that people are taking on debt to keep their spending up at normal levels. This year we have seen a 13% jump in credit card debt compared to a year ago, the highest rate of increase in 20 years. However, a case for a softer landing with regards to a US recession is that the US economy is driven by the consumers who are still relatively financially healthy. So, although debt is increasing, this is off a very low base. But increasing debt levels are a red flag.
The US Fed has implemented three 0.75% rate hikes in a row, and it is talking about another 1% to 1.25% in rate hikes before the end of the year, which indicates that it is serious about getting inflation under control. And for the first time, the Fed has acknowledged that it will hurt the job market with these rate hikes – a blow to our only green indicator on the recession scorecard. Currently US unemployment is sitting at just over 3%, but by 2023, the Fed is expecting that number to rise to above 4.4%, which is a steep increase in the unemployment figure over a short space of time. Should this indicator turn red, then we can expect a full-blown recession in 2023. We think the likelihood of this is quite high.
EU and the UK: energy crisis fuelling inflation and low consumer confidence
The European Union (EU) and the UK are facing similar issues and, as a result, their currencies are also adjusting. However, with the energy crisis, they are facing additional headwinds. Germany – the EU’s biggest economy, its manufacturing hub, and the driver of EU growth – has been hard hit by soaring electricity prices that have hit record highs. German power prices have gone up seven times this year. The price that industrial producers are paying for power increased 37% in July – the highest increase on record. Power prices, alone, are fuelling expectations that Germany is flirting with a recession, if not already there, with business and consumer confidence sitting at record lows. The potential scenario that Russia will reduce gas or energy supply even further – or may cut it altogether – as winter sets in is an additional headwind that will bring the possibility of an EU recession even closer.
Despite this, the European Central Bank (ECB) is aware that it needs to get inflation under control. The ECB is therefore being forced to raise interest rates. Their last rate hike was 75 basis points, which was the biggest rate hike in the history of the ECB, and it has brought the EU’s interest rates into positive territory for the first time in eight years.
In the UK, the proposed fiscal plan with tax cuts caused mayhem in the market. The International Monetary Fund asked the UK government to reconsider its policy, which, when announced, sent the UK bond market into a spin, seeing bonds being repriced and reaching levels we have not seen for years.
China, on a different trajectory
Compared to many developed markets, China is in a very different cycle. With their zero-COVID policy and ongoing lockdowns impacting the economy negatively, the country is not sitting with the same inflation problem as the rest of the globe. China is therefore not likely to be raising interest rates any time soon, so it is expected that China will have a very different 2023 to the rest of the globe.
In fact, the Chinese government is looking at stimulating the economy with a substantial infrastructure spend, which is similar to what we saw in 2016. This move led to a very strong commodity run, which will hopefully support emerging economies. The move has also supported business sentiment on the ground and is in line with some of the debt regulations that have already started supporting the economy, as the People’s Bank of China is committed to maintaining liquidity to support the economy. With continuous lockdowns due to its zero-COVID policy, China is being forced to revert to its old growth model, growing infrastructure, property and exports. The country has tried to switch its economy over to a consumer-driven one, which worked for a while, but COVID put pause to that.
The Chinese economy has been hit hard by the pandemic, and the World Bank has revised China’s growth outlook for 2022. This will be the first time since the 1990s that China will grow at a slower rate than its Asian counterparts. The new predicted growth rate is 2.8%, which for an economy like China’s can almost be considered recessionary. But if China can get COVID under control, it may actually do much better than other large economies in 2023. Even if it does do well, the world’s second largest economy will, unfortunately, not be able to save the global economy from a recession or growth disappointment.
We have not seen inflation at these levels since 1985. Without inflation, central banks were able to lower interest rates to zero, or even below, and a high level of complacency set in. When the global economy hit an economic hurdle, governments simply borrowed more money, with low interest rates making this affordable. Rising debt repayments create a very unhealthy environment for the financial system and investors are concerned. Which, again, raises the question, “Have central banks overreacted in raising rates at the pace they have?”
At Peregrine Wealth, we believe that we are facing a very different decade than we have for a while. To put that into perspective, since the turn of the century, when China joined the World Trade Organisation, globalisation reached its peak, and it marked a golden age for global economic growth. We saw economic growth numbers averaging around 3.5% per annum which is well above capacity. This environment has allowed companies to grow their profitability, and in real terms they were returning upwards of 10% per annum. The strong earnings growth in turn supported equity markets. We believe that in the next three to five years, global growth is going to fall below capacity and may fall below 10%. This period could also include a period of negative growth if the world dips into recession. But, for now, we can assume that developed economies will grow well below capacity over the next couple of years which creates strong headwinds for company profitability.
This will, however, depend on how central banks deal with the current inflation cycle and how quickly they can start to cut interest rates. We must remember that the interest rate hikes we are seeing now will only truly be felt by the consumer and the real economy in about nine months’ time. It is for this reason, that an overreaction by the central banks can have a very detrimental effect on the economy next year. By then it will be too late, as businesses will be under pressure and resulting job losses could lead to higher than anticipated unemployment.
So, when we ask, “Are we there yet?”, we are asking has the US economy reached peak inflation? In June this year, the US inflation print was 9%, in September this had fallen to 8.2%. One can argue that they are on a downward phase. So, looking to next year, in the worst-case scenario by the middle of the year, we may find ourselves looking at 6% inflation while the best-case scenario is that we will be closer to the central banks’ targets. These numbers require a lot of assumptions, however.
The first is that the price of oil stays the same or falls, but we know that we are in a world where oil is being used to fight a war. Russia limiting or cutting off gas supply completely to Europe over winter is a very real possibility which will put the oil price on an upward trajectory. This, in turn, will drive inflation higher, meaning central banks won’t have the luxury of slowing down interest rate hikes. If you assume inflation is falling, then we will most likely see a slowing of the pace of interest rate hikes by the end of this year. Although inflation is unlikely to reach the 2% range any time soon, slowing rate rises will give the global economy a softer landing.
Investing to sleep well, eat well, live well
Given the issues discussed, markets have taken a battering since the beginning of the year. The US’s S&P 500, alone, is down more than 20%. Typical safe-haven assets were not spared, and global bonds and gold have been negatively impacted as rates started to normalise.
It has been a very tough year so far, and there has been nowhere for investors to hide. The Peregrine Wealth investment team believes that the only thing that will preserve wealth in this environment is optimal portfolio construction and keeping our eyes open for opportunities – and there are still many good opportunities.
One such example can be found in the recent repricing of US bonds, which brought 10-year yields back to 4%. At these levels the asset class is a viable investment option again, having been unattractive for a significant period of time given the meagre yields on offer.
Also, it must be remembered that very tough years, like we have had in 2022, are historically followed by much better years, unless economic fundamentals get worse. This means we should see a strong rebound in many asset classes from these levels, despite the environment being quite challenging at the moment. However, we are going to have to remain agile as the next two to three years will depend on how central banks pivot and how quickly they start slowing interest rate hikes. This will not only impact the global economy but will also affect how quickly markets sentiment changes.
Now, more than ever, you need to stick to your cashflow plan. The first part of the plan is about “sleeping well”. You need to think about what money you are going to need over the next two years – your stable component, money in the bank that will experience no volatility. And because inflation is rising, it is best to keep this amount limited. You are not going to beat inflation with this money, but you can sleep well knowing you have enough to cover your immediate expenses.
Then, the next four to six years of cash will be invested into low-volatility investments, which have the potential to beat inflation and will act as a shock absorber during difficult times. Bonds should play a role in this part of your portfolio. This is the “eat well” category, where the purchasing power of your money stays intact.
Then, finally, the money that you do not need in the short to medium term, you keep invested in growth assets, which will predominantly be equity markets. We believe that you need a long-term investment approach and we advise against trying to time the market. Things change quickly and this year the markets have been extremely volatile. What needs to be remembered at this time is that equities are cyclical and over the long term will usually always beat inflation, meaning this part of your portfolio is your biggest inflation hedge. This is the “live well” part of your portfolio where in time proper real returns can be generated.
So, as we prepare for 2023, this year will be remembered for themes like the Ukrainian war, the return of inflation, and central bank wake up calls. The current environment suggests we are in for a couple of difficult years. It will come down to how central banks will balance liquidity in the system. But given how Peregrine Wealth constructs its portfolios, clients can rest assured that our processes and hands-on approach will ensure that over this festive season, and beyond, our clients can relax and “eat well”, knowing their wealth is being managed and monitored.