The economic outlook is one of slowing growth and raising inflation.
- Wednesday, May 18, 2022
The economic outlook for 2022, as predicted recently by both the Bank of England (BoE) and the US Federal Reserve (Fed) is one of slowing growth and raising inflation. The Fed is expected to see inflation peak first and is advancing interest rate hikes faster than the BoE is at present. We can expect rate rises throughout the summer and autumn as central banks seek to slow demand and control prices. As a result, bond yields will rise and prices fall. This should also push down equity values particularly for those companies with heavy borrowing and in sectors where the cost-of-living squeeze is hitting demand.
The markets we have been invested in have been hurt by the re-pricing of assets this year. At this rebalance we have assessed which assets we wish to hold and those we will relinquish.
Markets have been hurt by high inflation, interest rate rises, soaring energy costs and the Russian invasion of Ukraine. This cocktail of uncertainty has driven down the value of bonds and equity.
Usually, if equities are facing a difficult period, bond yields tend to fall and their prices rise. However, the rise in inflation has reversed the usual equity-bond relationship. This time the rise in yields is driving equity markets lower. We have therefore endured both the re-pricing of equities at the same time as the re-pricing of bonds.
Despite this outlook, certain sectors have prospered and in particular funds investing in natural resources, commodities, infrastructure, insurance and property have done well. Overall, the UK FTSE 100 has also done relatively well as it is made up of high- quality international businesses in these sectors. Gold funds have done well this past three months in particular but with bond yields raising and the US$ strengthening gold may lose its shine.
Analysts expect better returns over the next twelve months from equities over bonds. The forecast for bonds remains poor. For this reason, we will again reduce our weighting in fixed interest and where we have holding, they are either short dated, inflation linked, floating rate in nature, high yielding or hedged. These features should cope with the current circumstances better.
We have extended our positions in infrastructure funds, property securities, natural resources and maintained our holdings in sustainable energy. We have sold out of gold as we expect it to weaken on a stronger US$. Our defensive asset of choice is cash and we are overweighted for duration of the Edition 37.
For central banks to avoid a policy mistake, rate rises and quantitative tightening has to be communicated well and implemented gradually. With both the Fed and BoE have only really started their tightening recently and they have some catching up to do to get inflation in check. The Fed is expected to make 6-7 more rate rises this year. The Fed Futures are predicting six hikes. However, the squeeze on real incomes may do some of the Fed’s work for them and as a result only four hikes may occur. All eyes will be on inflation and job numbers.
Analysts are not expecting a recession in 2022 and if the Fed gets its rate rising programme right and we could avoid one in 2023 too. A high proportion of western consumers have enough excess savings to cushion the squeeze on real earnings and the cost-of-living rises. As the world continues to emerge from Covid restrictions then spending should continue.
As the Fed is raising rates at a faster pace than the BoE, sterling has weakened and may continue to devalue against a strengthening US$. The pound has lost 9% against the dollar so far this year. This devaluation will add additional inflationary pressures as commodities, for example, are priced in US$.
The BoE has predicted that UK growth will be 3.75% this year and -0.25% next year. The Bank expect inflation to hit 9% in Q2 and 10% in Q3 when the Ofgem energy cap is renewed, but fall back to 7% in Q1 2023. The BoE then expect UK inflation to be back to under 2% in 2024.
Of particular importance is the behaviour of the UK consumer. Households are under pressure from high energy, utility bills and recently increased NIC contributions. However, many households have built up excess savings over the past two years which will help. UK equities are currently attractive, particularly the high-quality cash generating international businesses. For these reasons we have increased our FTSE 100 and FTSE All stock holdings. The FTSE 100 will also benefit from a weakened pound.
Some fund managers are of the view we are at peak, peak war, peak US inflation, peak Covid in China and that things should improve from Q3 onwards. High inflation rates are painful for everyone not least those on lower incomes or benefits. Consumer confidence is falling but has the capacity to recover.
Inflation can be a good thing for goods manufacturers and services providers as companies can raise prices collectively which helps with longer term profits. The challenges are more towards heavily indebted sectors where there is insufficient growth or pricing power. In these times greater exposure to dividend producing large cap companies makes sense.
There has been a 10-year bull rally for growth style stocks over value style stocks. Now there is a catch up occurring with analysts suggesting an 18-month value rally ahead. The winning sectors would be the infrastructure, financials, commodities, energy and the underlying facilitators of growth. Value stock has better protection against inflation and interest rate rises.
Inflation and interest rate rises are less of an immediate issue in Asian economies. We expect China to start easing monetary and fiscal policy. Over the next few quarters, we can expect to see the effects of Chinese easing and investment as they come out of the Covid lockdowns. We have retained our modest Chinese holdings and have raised our Asian allocations.
While our equity holdings have slightly increased, we have significantly reduced fixed interest and hold more cash. Within the equity holdings we have reduced our exposure to Europe, Japan and emerging markets, but increased our holdings in the UK. Overall, we are more invested in income generating value stocks and large cap and mega large businesses. Examples of these holdings would be JP Morgan US equity income, T Rowe Price US large cap, Schroder Asian Income, HSBC FTSE 100 index and the L&G Global 100 index.
Chris Davies
Chartered Financial AdviserChris is a Chartered Independent Financial Adviser and leads the investment team.
About Estate Capital
Financial Services
Our Contacts
7 Uplands Crescent,
Swansea, South Wales,
SA2 0PA.
Tel: 01792 477763