Markets across the globe tumbled in 2022 as inflation surged and central banks were forced to hike interest rates, but fund managers expect there to be less of a focus on inflation over the coming 12 months.
Inflation has dominated the headlines over the past year. In the UK, the consumer prices index (CPI) stands at 10.7% and in the US it is at 7.1%, although these are far from isolated examples and most countries are battling with soaring prices.
This prompted a wave of interest rate increases – around 300 from across the globe in 2022. Most recently, the Bank of England last month took the base rate to 3.5% and the Federal Reserve’s base range is between 4.25% and 4.5%.
Performance of indices in 2022 (in local currencies)
Source: FE Analytics. Total return between 1 Jan and 16 Dec 2022
While this rate hike cycle have been the driving cause of the market falls shown in the chart above, investors expect inflation to slow in 2023 and central banks to ease up on their aggressive tightening policies.
Luca Paolini, chief strategist at Pictet Asset Management, said: “2023 will be a year when the investment environment slowly gets back to normality.
“Inflation will come down – even if not quite as fast as the market seems to expect. Economies will struggle for growth but manage to stave off a deep downturn.”
Indeed, there are signs that inflation has peaked in some major economies as energy prices stabilise and post-pandemic supply bottlenecks are overcome. The UK’s current CPI of 10.7% is down from 11.1% in the previous month while US inflation reached 9.1% in June before easing.
Paolini said this means inflation won’t be market’s primary driver in 2023 although it will remain “a hurdle”.
However, he warned investors about becoming too optimistic on how quickly it will fall, noting that the jobs market remains strong, which supports wages, and some sizeable components of the inflation basket, such as rents, are slow-moving and will take longer to come back down.
World monthly CPI inflation rate, year-on-year % change
Source: CEIC, Refinitiv, Pictet Asset Management. Data from Jan 2000 to Sep 2022; forecast from Oct 2022 to Dec 2023. GDP-weighted average of 40 countries’ inflation rates. Forecast in light blue dashed line.
The consensus that inflation will start to fall has also led some to speculate that central banks will be able to start lowering interest rates at some point in 2023 to tackle the recessions that were brought about by their efforts to stem inflation.
However, Paolini doesn’t think this is likely. Central banks will be cautious about starting a new easing cycle, he argued, and are fully aware of the risks of cutting rates before inflation has been properly suppressed, making them unlikely to start easing “anywhere near as quickly as the market expects”.
“To do so would risk another, even less controllable surge in inflation, which would shatter their credibility and force even more drastic efforts to get back to price stability,” he added. “We don’t think they will start to ease policy until 2024.”
BlackRock – the world’s biggest fund management house – agreed with this sentiment. Its strategists also expect inflation to fall significantly from its current highs but they think deep recessions would be needed to take inflation to central bank’s target rates.
It pointed to the US as a case study. Part of the Federal Reserve’s headache in tackling inflation is the upward pressure created by hard-to-address issues such as labour shortages caused by an ageing workforce.
Essentially, this means the US economy cannot sustain its current activity levels without also creating inflationary pressure. If the Fed is to meaningfully bring down inflation, therefore, it needs to close the gap between where the economy is currently operating and where it can comfortably operate in light of these hard-to-address constraints.
“That’s why we don’t see central banks reversing course by cutting rates as recession plays out,” BlackRock said. “They’re now creating recessions, not riding to the rescue as they did in the past.”
Ben Lord, manager of the £1.1bn M&G UK Inflation Linked Corporate Bond fund, said it is “perfectly possible” that in the next six months US inflation could fall from 7.1% to 3-5% and UK and European figures drop from around 11% to 4-6%.
“This will be a powerful and rapid move lower in inflation, and bonds will start to look (as indeed they already have) much better value as a result. Much more interesting will be what happens in the second half of 2023 and into 2024,” he added.
“Will the labour markets have weakened enough that public and private sector employers are facing down their workforces and taking wage growth to the required levels? Or will they remain strong and will wage rounds stay at elevated levels?
“If that’s the case, then as the Fed told us, rates will have to go higher than expected and stay there for longer than expected. But today, no one knows: not the markets, which are predicting a big hit to jobs markets to come imminently, nor the Fed, which is clearly concerned about the continued strength.”