Outlook on the economy
Inflation is still a hot topic
Inflation is still the main topic dominating the economy and financial markets in 2022. In Europe, inflation has now risen to 10% from a year ago. There are outliers upwards (Netherlands 17%, Baltic states above 20%) and downwards (France 6%). The high level of inflation can for the most part be attributed to the strong increase in food and energy prices. But even core inflation – which excludes food and energy prices – now stands at around 5%. Core inflation is particularly affected by job market developments. Unemployment in Europe is at an all-time low, creating opportunities to push for higher wages. Higher wages can in turn drive price increases – also known as the wage-price spiral. Still, this scenario does not seem very near at hand yet. Unlike in the past, trade unions have less bargaining power to enforce automatic compensation for price increases in employment contracts.
Also in the US...
Inflation seems to have peaked in the US. The US inflation rate has dropped a little, mostly on the back of lower oil prices. Multiple factors (such as freight rates, product prices and house prices) are hinting at a drop in inflation rather than further price increases. Yet at 6%, core inflation still remains high in the US. But here too, average wage growth lags behind consumer price trends.
How do central banks respond?
The inflation developments forced the central banks in Europe and the US to raise interest rates in 2022 more than initially expected. The main exception is the central bank in China, which is struggling economically and is facing only limited inflationary pressures. The most striking exception is Turkey, whose central bank keeps lowering interest rates despite inflation now exceeding 80% year-on-year. In the months ahead, it seems inevitable that at any rate the US central bank (the Fed) and the European Central Bank will continue hiking policy rates.
Our vision
Financial markets seem to be factoring in a stagflation scenario in the coming period: a scenario of high inflation and low economic growth. This is a realistic estimate in our view, at least for the next three to six months. As financial markets tend to be a step ahead of economic developments, the following question certainly starts to be relevant – what will happen next, from spring 2023, in the global economy? Will we return to the pre-Covid situation of ‘low growth / low inflation’? Or, conversely, will we see a situation of ‘high growth / high inflation’, fuelled by large scale government investments in defence and the energy transition?
A scenario of at most moderate economic growth prospects, combined with above-average inflation (i.e. higher than the central banks’ 2% inflation target), still seems the most probable in our view. We take into account slightly higher market rates here as they have already risen sharply in the past period. For equities and other riskier asset classes, such a scenario is not necessarily good news. In that regard, we believe there will be some considerable uncertainty for quite a while yet as to which scenario will eventually materialise. Corporate bonds might perhaps be a somewhat ‘safer’ choice. However, we are not counting on high returns for this asset class either in the time ahead as interest rates continue to rise. This calls for caution: we maintain an above-average cash position (money that is not invested) and an underweight in government bonds.