Financial & Economic Outlook for 2023

2022 was without doubt a bumpy ride to the extent that it registered as the sixth-most volatile year since the Great Depression and most economists are forecasting markets to ‘get worse before they get better’. In this blog, we ask Lothar Mentel, the Chief Investment Officer at Tatton Investment Management, to provide his analysis of those factors which have led to a cost-of-living crisis, rampant inflation and rising interest rates across all major economies and his near-term outlook.

The contributory factors for rampant inflation arising at the end of 2021 leading into 2022 are:

• The ending of Covid restrictions within the Western world which had created a pent-up demand to go out and spend money on goods, services and holidays. At the same time there were supply chain issues with factories (predominantly in the Far East) not producing at capacity, with containers and ships located in the wrong ports leading to demand exceeding supply.
• Central Banks believed the initial increase in inflation would be short-term and considered it transitory inflation, in the belief it would come back down. Therefore, they delayed any decision on raising interest rates, which is the blunt tool to curb spending.
• Russia invades Ukraine which caused price shocks in commodity and the energy markets and is undoubtably the biggest contributory factor to the current levels of inflation.

We asked: “What is the current situation with energy markets?”

Lothar: “Energy prices have actually fallen back quite a lot. We’ve seen it with the prices at the pump when we fill up our cars. But despite not feeling it yet from our energy providers, wholesale gas prices in Europe and in the UK have come down massively. As a consequence, Europe appears to have rallied quite hard and more so than the US recently. There is big relief everywhere that the big energy crisis and potential blackouts and everything else associated with that hasn’t happening and is unlikely to happen”.

We asked: “With inflation starting to subside across major economies do you think energy supply and associated costs will remain the main driver of inflation?”

Lothar: “If energy prices don’t go up anymore and they stay where they are, then because inflation figures are calculated on a rolling 12-month basis, inflation will fall back. Actually, this wasn’t really the big issue for the Central Banks and that’s why they said originally inflation was going to be transitory. They knew that there was enough supply of goods worldwide in order to satisfy demand and therefore that demand-driven price rise dynamic should be short lived. What caught them wrong-footed was that we were running into a labour shortage, and that labour shortage gave the labour side a much better negotiating position than usual when price shocks hit. Rather than just having to stomach the price shock and for all of us to feel a bit poorer because we didn’t want to let Ukraine down and therefore accept the consequences of sanctions, we were able to, or a lot of people were able to, negotiate higher salaries. That can kick off a wage price spiral, which really then makes inflation not just a one-off price shock, but a sustainable development as we had here in the UK in the seventies, with all the dangerous repercussions that can come from it.

Andrew Bailey, the governor of the Bank of England (BoE) tells us that he foresees inflation and prices coming down here in the UK, but what he hasn’t said is that unless the labour market eases and the shortage of labour is somehow mitigated, the BoE is likely to keep interest rates high. Inflation will fall to a certain point, but inflation won’t come from energy and goods anymore, but services which are mostly labour costs, and these will still be much higher than Central Banks are comfortable with”.

We asked: “Is the current labour shortage a consequence of people in the 50’s and over deciding not to return to work following Covid lockdowns?”

Lothar: “Yes, spot on! So, this was the surprise for economists and the Central Banks who felt that because the pandemic had not actually affected the working age population so much, there wasn’t anything to fear, as is classically the case after a big pandemic with many fatalities. But what was missed was that a lot of people just rethought their lives and decided ‘you know what, I might just stop working a bit earlier because it has shown me how quickly this might all end, I’m 55, maybe I was planning to work up to age 65, but I can afford it and therefore I’m off’, without there being enough people at the younger end to backfill”.

We asked: “Whilst Central Banks of the major Western economies are following the same policy of raising interest rates to combat inflation it appears the BoE have been slow to react or are they having to tread more carefully compared to say the US?”

Lothar: “While the UK has the highest inflation in the G7 world, it’s also got the most slowing economy. Interest rate rises are a good tool if you’ve got an overheating economy but they’re not a great tool when you’ve got a price shock driven inflation pressure scenario, as the UK has. That is why the BoE has been somewhat careful here, particularly because interest rate rises immediately effect consumer demand. In the UK there’s still mortgages out there which are linked to the base rate, and people have also been hit much harder than in the US by energy price rises. In the US with 30-year fixed rate mortgages, people may be a bit tied down if they want to move, because in the US you can’t move the mortgage with you, but otherwise they haven’t really seen a big drop off in their discretionary spending habits. That’s different in the UK and so the BoE has to be a bit more careful, although they appear to be using scare tactics in their communications to frighten people about really bad times ahead”.

We asked: “In the past when there has been a significant negative event, stocks and shares or equities have fallen in value whilst more defensive investments such as Government Gilts or other fixed interest bond investments have maintained steady values. That doesn’t appear to have happened in 2022, why is that?”

Lothar: “Yes absolutely. For a couple of decades, indeed since the end of the high inflation period in the early eighties, yields have fallen time and again until they hit around zero in and around the pandemic. As long as yields fall, that drives up the value of bonds, so over the last ten years we have seen returns from bond-heavy portfolios way above what you would normally expect over the longer-term. That’s now gone into reverse and corrected itself very, very rapidly because of the sudden inflation shock and rapid rise in interest rates. Normally, these sorts of corrections in the bond markets happen over a longer time period, not 12 months, which is what we saw last year. So, the big correction has happened and it’s very unlikely to happen again this year”.

We asked: “In spite of all the doom and gloom why have equities recently performed so strongly?”

Lothar: “Now the focus is again more on companies, on equities, on company earnings and the profits that they can generate. There will be an earnings slowdown or recession at least in the shorter term but financial markets quite often are willing to look through that and look ahead. At the moment, the consensus is building more and more around a scenario which is called a ‘soft landing’, which is what the Central Banks are really trying to achieve, i.e., slow down the economy enough so the inflation pressures go away, but not so much that we fall into a recession and it becomes really hard to get out of that again. The markets are also looking east again towards China. China may not have been that popular over recent years, but they are now coming out of almost a three year on and off lockdown. We all remember what life felt like in the spring of 2021 when there was a lot of talk about a return of the booming twenties being ahead of us. For the Chinese they have had an even longer time to save up, and there’s lots of pent-up demand there. So that will be a very welcome shot in the arm for global consumer demand just at the time when that should nicely compensate against some falling demand by consumers in the US and Europe. So, overall, there is increasing consensus that this end of cycle that we’re currently going through is going to be a little bit more benign than you would normally expect in a boom-and-bust scenario”.

We asked: “What is your longer-term view of Sustainable investments?”

Lothar: “There is still a very good investment case for the longer-term because society is really behind those aims. We need to make sure that the planet doesn’t overheat. We need to make sure that things become more sustainable so that future generations can still have a similarly enjoyable life to what we have and continue to enjoy. Tech stocks have fallen off extremely elevated levels over the last year or so and I’m less optimistic that they will come back very soon. Where people are perhaps looking at their ESG portfolios and wondering why it underperformed last year compared to conventional investments, well unfortunately, the fact of the matter is, when energy and resources are all of a sudden really in short supply, then those are the sectors that really rise quite a lot. And they are certainly the ones that you would not expect to see in an ESG portfolio. Therefore, you have a more restricted investment universe but it doesn’t change the long-term investment case, but may just make that shorter term investment experience a little bit choppier than it would be in a completely unrestricted portfolio.

The thing with ESG portfolios is that one of the main characteristics is, it’s investing into things that will be big and important in the future, which means that they’re probably not producing that much in terms of profit right now. That makes them growth stocks, as they’re called. When interest rates and yields rise, growth stocks do not perform as well as say value stocks. That’s also why a lot of technology stocks have come down in value. However, once yields do normalise, these things normalise as well, and increasingly there are returns to be made. Indeed, if you look at some of the wind farm activities, they have had some massive returns coming through and not all of them were skimmed off by windfall taxes”.

We asked: “Are financial markets still factoring in concerns around the Russia-Ukraine war?”

Lothar: “They have probably settled at a certain level of it not getting worse, but also not getting better and therefore being priced in to a certain extent. Obviously, things could still get worse but there’s also a possibility that with Russia increasingly coming under pressure, that there will be a settlement, at some point. Capital markets usually don’t really care that much about how wars are going, they’re more interested in what impact it has on the economy and one of the things that will come to the fore this year is that NATO has supported Ukraine with a lot of hardware from existing stockpiles. NATO countries now have to replenish those stockpiles which introduces a partial war economy for the West and that does drive activity. Whether it’s an activity that we particularly like is a different matter, but nevertheless it’s a manufacturing activity which could have a more positive effect this year compared to the negatives that we initially saw at the start of the war in Ukraine last year”.

We asked: “Do you think the pressure that the Chancellor of the UK finds himself under to reduce tax is going to come to fruition?”

Lothar: “I think over the longer term they will try to bring tax levels down again. But as we experienced last autumn, if you try to do that too aggressively, then internationally you get singled out as perhaps not being particularly creditworthy anymore. If your economic plan doesn’t seem to stack up then your yields can shoot up so much that actually the cost of finance becomes a far heavier burden on businesses than the burden of taxation. Therefore, at the moment I don’t expect any imminent reductions in taxation and we don’t see that anywhere else internationally either”.

We asked: “Thinking about the year ahead what would you say the positives are?”

Lothar: “The positives are, for example, that with the US economy slowing somewhat the dollar has declined a good 10% already and the weaker dollar usually does help the rest of the world – emerging markets, but also the UK – because it stimulates global trade. Further positives are that we’ve not seen Europe suffer from the energy crisis quite as badly as had been anticipated and therefore there’s better news flow coming through on the macro data side. That growth boost that we’re going to get from China is going to be quite a positive one as well, so all in all, it doesn’t look anywhere as grey and dark anymore as it did perhaps three months ago”.

Our thanks to Lothar.