Thoughts from our strategic partner Elston Financial. The RBA had hoped to deflate the inflation balloon gradually. But that hasn’t happened.
Inflation has proven to be more stubborn than expected. And so, the Reserve Bank has had no choice but to keep increasing interest rates. The problem is the cumulative effect of all these rises could lead to an abrupt correction, popping the economy into a recession.
What could this mean for company earnings, and how might that flow to portfolios? Elston Portfolio Manager Leon de Wet has been thinking about it lately. So we asked him to give us his view on things. In recent months we have been cautious about the outlook for 2023. That’s because Central Banks are fighting inflation by using higher interest rates to increase the cost of capital and drain liquidity from the economy. This will ultimately lead to slower growth.
The magnitude of monetary tightening by Central Banks globally has been staggering. It’s been on a scale most investors have never experienced. And yet, the global economy has proven to be remarkably resilient so far.
The impacts of monetary tightening have a lag. While it’s difficult to predict the lag, it can typically be between 12 and 18 months. We are currently ‘smack bang’ in the middle of the 12 to 18-month period following the first RBA rate hike.
We continue to lean toward possible shallow recessions across developed markets in the year ahead. But even if we’re wrong about history’s most anticipated recessions, economic growth will slow, including here in Australia. This will, in turn, weigh on the ability of ASX companies to grow their earnings.
The good news is that headline inflation has peaked in most regions, with the biggest contributor being the decline in energy prices. The oil price was down from $130 per barrel (just after Russia invaded Ukraine) to $70 per barrel in mid-June. Unfortunately, as we expected it would be the case, core inflation (which excludes more volatile food and energy costs) is proving stickier.
Global inflation (YoY %)
Source: Citi Research, National Statistical Sources, Haver Analytics
Services inflation remains stubbornly high.
Wages make up the majority of inputs for service industries, and with labour markets in many developed markets still, tight, it’s hard to see wage growth receding without the jolt of a recession. As a result, major Central Banks appear to be opting for the risk of tightening too much to avoid anchoring inflation expectations higher.
The RBA has certainly increased rates more than we had initially expected. Will they rise again? The market seems to think so. The market has already priced in the impact of one more 25bp rate rise.
Source: PIMCO Australia Management
We expect it to take time for core inflation to decline closer to target levels. Therefore, interest rates will also take time to ease. The potential for accidents, however, remains high.
As such, we see both upside and downside risks to our economic growth expectations. If our base case is wrong, the likelihood of a severe recession seems higher than a soft landing. Still, we may be underestimating the possibility of inflation declining with lower costs to economic activity than we now expect.
To conclude, stubborn core inflation, tighter financial conditions, and central bankers that are slow to cut policy rates to boost growth mean distinctly sub-trend economic growth and declining company earnings.