We are just starting to see improvements in equity and bond markets.

A recession is looking likely, but on different timescales and depth of impact. The recession will be modest in the US but deeper in in the UK and Europe but this will depend upon inflation falling. If inflation remains elevated then central banks will need to continue with interest rate rises and business and household struggle with higher costs for goods, services, and credit. The consensus is however that inflation will peak and that central banks will stop rate rises during the first half of 2023.

The main reasons that inflation will start to decline are; Supply chain pressures are easing, commodity prices are falling, higher costs will cool spending and higher interest rates will impact borrowing and investment.

The reasons that a recession will be modest are; inflation is expected to fall, cash savings for both corporations and households remain healthy, the banking sector is robust and governments will support families with the energy cost.

The main challenge to this outlook is that inflation remains stubbornly high. If Russian was to renegade on the wheat supply agreement will not help food costs nor would further extended lockdowns in China as they continue to pursue a zero covid policy. However, on the upside for inflation pressure is the falling gas and oil price.

On top of interest rate rises, the BoE has just started to sell back to the market the bonds it bought due to quantitative easing (QE). The BoE electronically created new money, which it used to buy government bonds issued by the Treasury to fund government spending. QE helped to keep market interest rates at historic lows. By selling the bonds back it removes cash liquidity from the economy and tightens money supply. Quantitative tightening is counter inflationary.

Analyst forecasts are that headline inflation will fall significantly in 2023. A fall in headline inflation will help take pressure off consumer finance and prompt the slowing of the pace of rate hikes from central banks as it reduces inflation expectations. Services inflation is in the UK a key measure as it includes the domestic component of wages which are rising. A combination of central tightening and a cost-of-living squeeze will help to reduce demand, ease labour market tightness and therefore wage growth in 2023.

With an outlook of declining inflation and that interest rates will at some point over the next six months peak we are starting to see improvements in volatile equity and bond markets. On the back of stabilising yields then short dated UK gilts or investment grade corporate bonds look far more attractive.

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