In the 1993 film, Groundhog Day, Bill Murray lives the same day over and over again. That feels a little like our current situation with markets, inflation and interest rates. Just like in the film, there will come a time when we break out of the loop but we’re not there yet.
In the UK, the Office for Budget Responsibility forecast that the UK would avoid recession this year but it was not expecting much economic growth. Since then, inflation has remained at elevated levels, the Bank of England has increased interest rates to 5% and we have had further ructions in mortgage markets with most fixed rates now at around 6%. While inflation has been a global issue, impacted by post-Covid supply and demand pressures and the Ukraine war impacting on energy and food prices, the UK seems to have been particularly susceptible. There are a number of structural reasons for this. Firstly, there is an insufficient supply of labour following Brexit, people retiring early and long-term ill-health which is not being helped by the issues in the NHS; when companies find it hard to recruit they increase salaries to attract applicants (private sector wage inflation is currently at 7%). Secondly, we import a lot of our goods and even where we produce our own (50% of our energy) we are still exposed to global prices. Thirdly, the energy price cap which is designed to cushion us from volatile prices (believe it or not) works slowly when prices are falling; wholesale gas prices are currently back to levels in June 2021 but we won’t see that in our bills for a while. While inflation, measured by Consumer Price Index (CPI) has dropped from a high of 11.1% in October 2022 to 8.7% in May 2023, core inflation, which strips out energy and food, is rising (to 6.5% in May 2023). This is what the Bank of England is concerned about. Energy prices are falling and food inflation will moderate but if core inflation remains sticky, then there is a chance of getting into an inflationary spiral which would be very damaging.
With rising mortgage rates coming on top of a cost-of-living crisis, it would not be a surprise to see the UK consumer reigning in spending as 2023 progresses. During May, UK households withdrew £4.6 billion from savings, the highest level of household withdrawals on record. With retail sales remaining positive, this suggests that high savings from lockdown are being spent in what may be a ‘last hurrah’ before consumers start to tighten their belts. UK job vacancies have started to fall from a record high but there are currently 1.08m vacancies versus 1.3m unemployed people actively seeking work and the employment rate continues to increase. So, while we may see a ‘spending’ recession, a deep recession with high employment and high vacancies would be unusual, although conditions can change quickly.
In the US, the Federal Reserve has paused interest rate rises for the time being as it waits on further economic data. Inflation has dropped significantly (to 4% in May) but core inflation remains elevated due to a strong jobs market and solid economic growth. Recent indicators have shown higher manufacturing growth, higher home sales and a confident consumer. The Chinese economy is growing below par following its re-opening from Covid restrictions but the government is starting to employ more policies to support growth which could be beneficial for the Asia region as a whole.
Economic views are more mixed than we have witnessed for a long time. There are those who believe the monetary tightening we have witnessed will inevitably lead to recession (there is a lag of 18-24 months), those who think we will witness a slowdown but once inflation has been contained interest rates can be cut and growth will resume and those who believe strong employment will keep economic growth positive.
Markets
It will come as no surprise that markets remain volatile and impacted by flows of news around inflation, interest rates and economic growth. However, since the last update in March 2023 markets are generally higher with the S&P500 returning 9.25%, Europe up 4.71%, Asia up 3.69% and the UK market up 2.61%.
In volatile conditions it is easy to get caught up in short-term issues and investment returns. Sometimes it is useful to take a step back and look at longer-term trends. Over the last five years we have witnessed a global pandemic, inflation rates not seen for forty years, the Ukraine war and its impacts, and a return to interest rates not seen for 14 years. Yetequity markets have provided positive returns over this period, led by the US where the S&P500 has grown by over 80%.
I suspect that market volatility will remain a feature until the trend of inflation and interest rates, and its impact on economic growth, is more certain. This is likely to result in larger swings between asset classes over short periods as relative value waxes and wanes, but retaining a well-diversified portfolio provides exposure to a broad spread of potential returns.
Inflation vs corporate profits
Owning shares in listed companies is often cited as a way to protect savings against inflation. Whilst shares over the last year have not kept pace with the high inflation we have seen, over the longer-term shares have substantially outperformed inflation. The current conditions are proving why this remains true. Higher inflation means workers demand higher salaries which, together with higher input costs (energy, goods etc) pushes up costs for businesses. However, companies have the ability to pass these higher costs onto their customers to maintain profit margins. Whilst this adds to the inflationary problem, we have witnessed this over the last year with a wide range of companies reporting higher costs but also higher or maintained profits. Whilst this might not be good for us as consumers, it is positive for share prices.