The New Year comes with a sense of renewal and optimism’

The widely held anticipation is that inflation will now fall and could do so quite quickly through a combination of fundamentals and technical factors. From a technical perspective, the fact that rates of inflation have been so high makes it harder for them to continue at the same pace. Similarly, the very high month-on-month rates of inflation suffered over the last 12 months will gradually drop out of the annual inflation rate.

At a fundamental level, energy and many food prices, which tend to be the most volatile consumer prices, were weakening towards the end of 2022. Inflation is therefore likely to continue to fall over the coming months. That has led investors to expect interest rates to increase more slowly, pause and eventually fall.

Recent data prints supported that theme with early provisional inflation figures from Germany and France both showing falling inflation. The most telling and anticipated release was the latest US consumer price index (CPI) report where headline inflation slowed, reflecting weakness in volatile energy prices.

This alone will not sway many policymakers who naturally focus on more stable core inflation. Here, the annual rate of inflation slowed once more, but even the last few months remain at a pace that would be inconsistent with the Federal Reserve’s inflation target. Nevertheless, the big picture is that inflationary pressure is moderating. 

Will we fall into recession in 2023?

Low inflation and falling interest rates have historically been an accommodating environment for investment. Usually, these are closely followed by recovering economic activity. The challenge, at the moment, is the economy does not seem to be doing badly enough.

 Although surveys continue to show that confidence among businesses and consumers is very depressed, last year’s pessimism was driven by the challenges of dealing with inflation, rather than because demand for either labour or products was weak. Understandably, the expectation is that the contraction during 2022 in real incomes will lead to a recession in 2023, but it’s far from certain.

Consumers have been able to dig into cash reserves to weather last year’s inflationary storm (particularly in the US). It has left the savings rate at what seems like an unsustainably low level. But recent months have seen real incomes rising because, in the very short term, inflation has slowed while wages continue to rise. So, a big question is whether the trend for wages continues or whether it falters, as it would if the US were dropping into a recession.

What is happening in the US?

The non-farm payroll report, which showed robust jobs growth again in December, indicated that the pace of jobs growth is historically healthy, although it has been declining steadily over the last year and continued to do so in December. 

This doesn’t necessarily mean the labour market is easing and, as things stand, there seem to be jobs for anyone who wants them, resulting in the unemployment rate falling to 3.5%, which is the lowest it’s been in more than 50 years. All of this should make the Federal Reserve nervous, but there are mitigating factors, including the fact that one year of high inflation is assumed by most consumers to be a one off. 

The inflationary expectations have not risen materially, which perhaps explains why wage inflation has begun to slow despite the worker shortage. This means the Fed’s worst fears of a self-reinforcing cycle of higher prices, causing higher inflation expectations, which in turn cause higher wage demands that can only be met by raising prices (the so-called wage-price spiral) does not seem to be taking hold.

What is happening in the UK?

The UK reported an estimate of gross domestic product (GDP) growth during November which rose a mere 0.1% rather than declining as had been expected. Football-related hospitality spending was a contributor driven by the World Cup. 

It is now in the balance whether the UK’s recession began in the last quarter of 2022. That will depend upon spending during a December that was dogged by snow and strikes though early signs suggest it was a buoyant festive period for the high street as Tesco, M&S and Greggs all posted strong trading updates. 

The cost pressures for others, has proved more challenging, with Halfords issuing a profit warning and owners of the Byron Burger chain announcing further downsizing measures, with restaurants creaking as consumers stay home. 

The most difficult period for the UK looks to be the coming six months, with cost-of-living grants being suspended in the first quarter. In the second quarter, taxes and utilities bills will rise, and around two thirds of mortgages are expected to require refinancing during 2023 at higher interest rates.

Looking ahead 

There may be some telling economic pain to come both at home and abroad but as inflation and interest rate expectations begin to settle down, there is hope that markets are once again looking at company fortunes with a more medium to long term lens.

Written and prepared for Crowe Financial Planning UK Limited by John Moore (Senior Investment Manager at Brewin Dolphin)