We face a painful economic crunch this winter before we can look to recovery in 2023.
Uniquely, the Composite PMI for UK, Eurozone and US were all at 47.2 in September, indicating the likelihood of recession for all. However, each economy is at that point for very different reasons.
The UK government faces an economic trilemma of risks from inflation, recession and its twin deficits. Europe and the US are also heading for recession, though for different reasons. Over half of Europe’s inflation is from energy prices. This energy crisis is pushing Europe into recession but, as a positive side-effect, that recession will resolve the inflation problem. By contrast the US inflation problem is home-grown and so the US Federal Reserve will have to continue hike rates further and faster to engineer a recession to remove these inflationary pressures.
PMIs Converge into recession territory
Past performance is not an indication of future performance
Source: Columbia Threadneedle and Bloomberg as at 25 October 2022
An extraordinary amount of economic changes have been compressed into this year
We seem to have experienced almost the full range of an economic cycle inside a single year. There have been post-Covid bounce-backs in economic activity, bottlenecks in supply chains driving inflation, an energy crisis, the highest inflation in forty years for developed economies, and economic slow-downs. The fact that some countries, notably China, have persisted with Covid lockdowns further complicate the picture.
Central banks have unsurprisingly struggled to keep up in this environment. The lingering risks of Covid meant they were late in responding to surging inflationary pressures. In July the expected interest rate for mid-2023 was still 3% in the UK, US and just 1% for the Eurozone. In the next two months, those expectations jumped by two percentage points or more.
This unpredictability and instability has been reflected in huge volatility in asset markets. This has increased the risks of financial accidents. A policy mistake in the UK led to a market melt-down which threatened a full-blown financial crisis and brought down a Prime Minster before it was resolved.
Big Rise in interest expectations since July
Source: Columbia Threadneedle and Bloomberg as at 25 October 2022. Estimates and forecasts are provided for illustrative purposes only. They re not a guarantee of future performance and should not be relied upon for any investment decision. Estimates are based on assumptions and subject to change without notice.
We think that the housing market will prove the weakest link in the UK economy
While the UK was not a significant importer of Russian gas, its high dependence on gas has proved to be costly, as prices reflect the impact of the European gas crisis. Government intervention should alleviate the worse of impact for households and potentially avert recession this winter.
Rising mortgage rates will be an additional burden on households already under severe pressure and will likely tip the UK economy into recession in 2023. The problem is made less acute by the prevalence of fixed-rate, fixed-term mortgages, a reduced proportion of households with mortgages and overall lower gearing. However, this issue will ratchet up as interest rates increase further and we expect house prices to fall in 2023 from current, overvalued levels.
Twin deficits for both budget and current account are set to expand making the UK vulnerable to (another) financial accident and we expect sterling to be under pressure.
Mortgage payments set to squeeze incomes
Source: Columbia Threadneedle and Bloomberg as at 28 September 2022
Risk assets have tumbled but we fully expect more attractive buying opportunities next year
Falling PMI translates into lower earnings growth and a US recession has always been accompanied by a fall in the stock market. However disappointing earnings won’t be a surprise to investors, and we would expect buying opportunities to emerge in equities in 2023.
The sharp rise in real interest rates negatively affects the pricing of long-term growth stocks. We continue to favour value over growth.
Interest rate expectations now appear plausible, with the forecast peak high enough to tackle inflation. As a consequence, US bonds and especially TIPS are no longer bad value. Cash also now offers a positive return and so a haven in the face of market and economic risks.
Higher interest rates will support the US dollar. Sterling will be under pressure from twin budget and current account deficits.
Analysts’ earnings growth forecasts have fallen… and are set to fall further
Source: Columbia Threadneedle, Bloomberg and Datastream as at 19 October 2022. Model is based off US Manufacturing and Services ISMs. Estimates and forecasts are provided for illustrative purposes only. They are not a guarantee of future performance and should not be relied upon for any investment decision. Estimates are based on assumptions and subject to change without notice.
