Stagflation still looms large over developed markets in 2023

By Jacobus Lacock, Fairtree Portfolio Manager

Recession, instead of stagflation, has become the watchword in financial markets at the outset of 2023 as the global economic impact of the substantial interest rate hikes last year take effect in the first half of this year and inflation retreats. But the threat of stagflation – stagnant growth and high inflation – remains alive and well, particularly in developed countries.

The problem is core inflation. While we expect headline inflation, which includes fuel and food prices, to fall rapidly over the coming months, we disagree with the market’s view that core inflation will return to central bank target levels of around 2% soon in the developed world. Tight labour markets, sticky services inflation and improving growth dynamics in China are all factors that could keep core inflation rates higher as economies come under recessionary pressure.

The near-term decline in inflation we’ve seen in the US, Europe and the UK will provide developed market central banks with the opportunity to continue slowing the pace of tightening and potentially pause over the next few months. But we disagree with the current view priced into markets, which is that the US Federal Reserve and other developed market central banks will begin cutting rates significantly from the second half of this year to around 3% by the end of 2024.

On the growth front, we expect the tightening of financial conditions by developed market central banks last year to impact growth this year negatively. The cost of living remains high, and real incomes for households stay in negative territory. Leading indicators, inverted yield curves and business surveys are signalling a likely recession over the coming 12 months. We agree but expect a shallow recession because households in developed markets are well-positioned to provide some buffer to tighter economic conditions. Households stand to benefit from tight labour market conditions, low unemployment and excess savings built up during the pandemic. As inflation falls, their real incomes and confidence will start to improve, which reduces the likelihood of economies falling into a deep recession. However, stagflationary conditions will persist, with inflation still stuck at higher levels and economies experiencing low growth.

Last year we were most worried about European growth as the cost of energy independence from Russia weighed heavily on European consumers and businesses, and the European Central Bank (ECB) continued hiking interest rates. Two significant developments occurred late last year that made us more optimistic about the European outlook. Firstly, energy prices declined sharply, and secondly, China dropped its zero-Covid policy in December and started re-opening its economy. These developments will alleviate some of the intense price pressures of inflation and boost growth in Europe as Chinese demand picks up. We now feel more optimistic about European than US growth but expect growth to come close to zero in the region this year.

We feel more optimistic about the outlook for emerging markets, where inflation has been chiefly headline driven by higher food, fuel and import prices. These prices are now coming down because many emerging market central banks started their hiking cycle earlier than in the developed markets. Thus, they don’t suffer the same core inflationary pressures. We expect central banks to cut rates earlier and more times to support emerging market growth. China’s re-opening may provide an additional boost to demand for commodity exporters and the tourism sectors. With global interest rates peaking, the US dollar weakening, and emerging market equity and bond market valuations favourable, the outlook for emerging market assets has improved.

China’s re-opening is the most critical recent macro development and will shape the global economy during 2023. The decision to remove the stringent Covid-Zero regulations came earlier and was more aggressive than expected. A major Covid wave ensued towards the end of November, likely to have peaked during January 2023. Economic activity first stalled during this wave but is now picking up rapidly. We expect activity to normalise by the end of the first quarter.

As the economy re-opens and confidence improves, we believe there is ample scope for household consumption to contribute to growth. When the Covid-Zero policy was in place, effectively closing the economy, households did not spend and could build up considerable savings. At the same time, the property sector was in the doldrums, and household mortgages collapsed, leading to household deleveraging. Thus, we expect spending on services, tourism, and luxury goods will improve.

The Central Economic Work Conference (CEWC) reiterated the policy objectives laid out during the 20th Communist Party Congress. The priorities remain growth, improving confidence, supporting household demand, alleviating youth unemployment, support for the private sector and property stabilisation. These imperatives and the recent easing of regulations governing property developers and the People’s Bank of China’s ongoing monetary easing will improve business conditions.

Longer term, we continue to see the US-China relationship as a significant source of geopolitical uncertainty. Recent bilateral meetings have eased some of the tensions, but the One China policy and competition with the US will create volatility. The US can’t afford to enter a geopolitical battle with China when its attention needs to be focused on the Russia-Ukraine war and managing tense Middle East relations. We still expect the war between Ukraine and Russia to be long and drawn out. Economic sanctions may have peaked. However, it is uncertain what impact the existing energy sanctions will have on the oil and energy market in coming quarters.

Energy prices have decreased primarily because of moderate winter weather in Europe, excess gas reserves, new gas supplies and changing consumer behaviour. Oil prices are under pressure from the potential for slower growth, but China’s re-opening may offset some global growth risk and thus increase oil demand. We believe the risk to oil prices remains on the upside from current levels of between $80 to $90 a barrel. Tensions between the US and Iran over a nuclear deal pose further upside risk.

We are optimistic about commodities in general, not just because of improved demand from China and the ongoing push towards a greener economy (which is very commodity-intensive), but primarily due to the lack of supply and investment in commodity production. A strong US dollar weighed on commodity prices, including gold, for most of last year, but the likelihood of a weaker US dollar this year may reverse that.

US dollar valuations remain stretched, but with the divergence in the US versus Europe and China growth outlooks, and the Fed close to pausing rate hikes, we see further downside for the US dollar. On the other side, we see an improved outlook for the South African rand based on China’s improving growth prospects, strong emerging market foreign portfolio flows into domestic assets, and stronger terms of trade. However, local economic dynamics remain weak, offsetting these strong external tailwinds.

Investor, consumer, and business confidence in South Africa remains weak in the face of more intense load-shedding, labour strikes, higher interest rates, high food and fuel prices and high unemployment rates. We expect South Africa to experience a few difficult months as consumers and businesses grapple with the lack of energy. It remains highly uncertain when and how we will see fewer power cuts despite the government’s best efforts to turn around the situation at Eskom.

We expect economic growth for this year to come in around 1%, adding risk to the fiscal outlook. But we believe the SARB is reaching the end of its hiking cycle. Inflation has rolled over, and – in contrast to developed markets – core inflationary pressures are surprising to the downside despite rising inflation expectations among businesses and unions. The scope for rate cuts may improve towards year-end. We are encouraged by the improved standing of President Ramaphosa within the ANC, as it provides scope for ongoing – and potentially accelerated – economic reforms.

This year is not going to be easy. The global economy will likely face a prolonged period of stagflation, characterised by stagnant growth and high inflation, which could necessitate more active intervention by central banks. The risk of geopolitical conflicts is also expected to remain elevated.

Against this backdrop, we expect cyclical opportunities in growth and defensive stocks to present themselves. Investors will need to complement their bottom-up analysis with a strong macro top-down view of the global economy and financial markets if they are to capitalise on these. Success will also lie in maintaining flexibility and humility and diversifying across sectors and asset classes.

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