By Gareth Gettinby

 

2022 was always going to be a tough year for markets. The need for interest rate rises to counter inflation is due to a variety of pressures including supply chain bottlenecks, the opening up of economies after pandemic lockdowns, the unwinding of pent-up demand, and high levels of savings put in place when people had nothing to do.

The Russia-Ukraine war added a full-on energy shock to the global economy, elevating inflation further and adding to investor woes.

As result, most assets were sold off and left few places for investors to hide. Since the middle of June, however, risky assets have staged a remarkable recovery as many commodity prices fell, reversing much of the previous gains.

This apparent “recovery” has raised investors’ hopes that inflation will ease. In addition, a significant consensus underweight position in equities has seen a short covering squeeze. This has seen equities recover half of their year-to-date losses since the middle of June.

Investors are now debating whether the US is in a recession or not. Recently there have been confusing signals. Real GDP has declined for two consecutive quarters – sometimes referred to as a ‘technical recession’.

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On the other hand, the US labour market continues to expand at a healthy rate. Activity data is still holding up as the US services sector surprised in July, driven by improving business sentiment and new orders data − all of which counters the argument that the US is in a recession, nor is it imminently heading into recession.

This gives the Fed the green light to keep raising rates by large increments as it continues to tackle inflation, rather than slowing the rate of its monetary tightening activity, which is what the markets are looking for.

Fears of a significant slowdown are greatest in Europe and the UK. The winter ahead is going to be bleak, particularly for consumers as the cost of living continues to squeeze. Increasing energy costs will continue to take a larger proportion of income, souring investor confidence further.

Whilst many commodity prices are lower than they were at the beginning of the Russia-Ukraine conflict, it seems French and German power prices are hitting new records on a daily basis; power prices are around six times higher than a year ago.

With increasing gas prices and the threat of Putin fully shutting off the supply of gas over the winter, there is a need to cut our power consumption. Last month, EU countries agreed to reduce gas use by a voluntary 15 per cent.

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The Spanish government have brought in regulations – mainly for businesses – that place limits on the use of air conditioning and heating. Whilst we may be in for a difficult winter as gas prices continue to soar, changes to our energy-use habits will likely be long-lasting.

Where do we go from here? Any sustained recovery in risk assets will be challenged. The most obvious factor is ongoing geopolitical events, and to my mind a lot will hinge on Ukraine.

There is a lot priced into assets, both in terms of higher interest rates and solid earnings expectations. If we saw something in Ukraine that allowed energy prices to fall and food supplies to unblock then inflationary pressures could ease, lowering the need for central bank action. Consumer and business uncertainty could ease as a consequence.

But without this positive outcome the outlook for the next 12 months is grim. There will need to be a recession to reset inflation and the upward creep up in inflation expectations.

READ MORE: Bank of England raises interest rates to 1.75 per cent

The outlook for companies remains challenging. Over the past few years central bank and government policies have stimulated economies, which resulted in strong corporate profitability. The second quarter of 2022 has been no different; in aggregate, profits have been strong, albeit the energy sector has provided a large boost.

Companies have so far been able to pass on spiralling costs to buyers, or absorb those costs themselves. This cannot continue indefinitely, and there are signs that consumers are beginning to resist higher prices.

As such, margins will be squeezed further if inflation remains elevated for longer. Finally, many companies that refinanced their debt during the low interest rate environment over the past couple of years will struggle to refinance their debt again at attractive rates.

Given a backdrop of stickier elevated inflation and tightening financial conditions, risks to growth remain and caution is warranted. The US should fare better than Europe and quality companies should do better than those that are highly sensitive to economic conditions.

Gareth Gettinby is investment manager at Aegon Asset Management