An energy supply shock of historic proportions is squeezing the UK and eurozone. Russia has halted gas deliveries to Europe via the Nord Stream pipeline indefinitely, and wholesale gas prices are more than three times their 2015 - 2021 average.
Policies like the UK’s freeze on household and business energy prices, albeit revised, should help to cushion the blow in the short term, limiting the hit to real incomes. France has a similar ‘tariff shield’ policy, Germany has its own “protective shield” plan, and other governments across Europe have announced a variety of alternative measures to protect households from the full force of surging gas prices.
Even so, recession seems highly likely. The UK economy has already begun to shrink, while the latest business surveys from the eurozone are also consistent with contraction.
Energy bills will still be high by past standards. In the UK, for example, Ofgem’s price cap on gas and electricity has been frozen at levels equating to £2,500 annually for the average household’s consumption, compared with £1,971 currently and £1,277 at the end of last year. Without a freeze, the cap could have risen to more than £5,000 in early 2023. The Bank of England remains focused on reducing inflation “no ifs no buts” and is likely to increase interest rates much further in response.
The economic outlook in the US isn’t quite as bad. In contrast to Europe, it is well insulated from the Russia energy shock. It has a much greater degree of energy independence, and wholesale gas prices have risen by far less there than they have in Europe. Americans are starting from a position of relative strength too — we’ve written before about the large cushion of savings that they amassed during the acute phase of the pandemic.
Even so, a recession there in the coming quarters still appears more likely than not as the US Federal Reserve aggressively raises interest rates in its fight against high inflation. (For clarity, we’re not counting the two quarters of falling GDP in the US earlier this year as a recession — that had more to do with big swings in inventories than broad weakness in the economy.)
The parts of the economy most sensitive to interest rates are starting to struggle, with the housing market the most obvious example. Home sales have already dropped by more than a quarter from their January peak, new building permits are down 10%, and the forward–looking components of key housing surveys suggest that more weakness is on the way. The housing market matters a lot (and is a key input into our quantitative estimates of recession risk) because it has a long track record of leading the economic cycle in the US more broadly.
The outlook for inflation
On a more positive note, we’ve probably already seen the peak in US inflation. The decline in global oil prices means that energy inflation there is now in retreat and should fall much further by the middle of next year. Goods inflation has been falling too, as last year’s pandemic– induced disruption to global supply chains has continued to unwind. The strength of the dollar has helped too, as it means Americans get more bang for their buck.
Nonetheless, it’s still too early to declare victory. Headline CPI inflation is still above 8%, and there’s lots of uncertainty about the downward path. The Atlanta Fed’s measure of nominal wage growth is still running well above 6%, with the tightness of the labour market indicating that it will fall back only slowly. At the same time, the prior strength of the housing market is still pushing up shelter inflation, which is uncomfortably high. The recent weakness in housing will take a long time to filter through fully to the inflation numbers.
Closer to home, the inflation outlook arguably looks even more difficult. Admittedly, the decision to freeze households’ means that the UK should avoid the huge surge near-term in utility bill–driven inflation that had previously seemed likely. But now the freeze is set to last in full only until April 2023, rather than October 2024 as previously planned, there’s a lot of uncertainty about what happens thereafter. We simply don’t know yet how far bills will rise.
Whatever happens to energy bill, there are also a few reasons to be worried about inflationary pressure more broadly. Growth in the UK’s labour force has been worryingly weak recently, helping to keep the labour market very tight. And in contrast to the US, recent currency weakness will only add to inflationary pressure in the UK and Europe.
Bringing everything together We find it helpful to think in terms of four key economic scenarios. These four scenarios are:
i) a typical demand–driven recession, in which inflation falls significantly (to below 4%) in 2023;
ii) stagflation, a recession in which inflation stays uncomfortably high (above 4%) next year;
iii) a ‘soft landing’, in which inflation comes down but recession is avoided (the outcome policymakers are striving to achieve);
iv) inflation resilience, in which the economy continues to grow but inflation remains too high throughout next year.
We’ve assessed the probability of each using a combination of quantitative modelling and qualitative judgement. We think that the probabilities of each scenario are slightly different in the US compared with Europe (including the UK).
In both cases, we think that a recession is more likely than not. But we judge that the chances are higher in Europe than in the US (a combined 90% versus 75%), given the weaker starting point and greater vulnerability to the Russia energy shock. Meanwhile, we suspect that the likelihood of inflation remaining uncomfortably high are also greater in Europe (a combined 40% versus 15%), reflecting a combination of energy costs, currency weakness and fiscal loosening.
This feeds into our strategies in a few ways. Reflecting the still–significant risk of inflation remaining high, we’re still underweight conventional government bonds, instead favouring other diversifying assets (including a variety of actively managed strategies) and cash. With the chances of recession high globally, we are also positioned very cautiously, both reducing equity–type risk overall and favouring defensive sectors over ones with more exposure to the economic cycle.
Reflecting the tougher economic backdrop in Europe specifically, we’re underweight European equities, which we don’t think fully reflect the likely scale of the downturn there. We’re also cautious about smaller UK stocks, though the FTSE 100 may provide some resilience given its skew to defensive sectors and preponderance of multinationals earning most of their revenue overseas.
Oliver Jones is an asset allocation strategist at Rathbones. The views expressed above should not be taken as investment advice.