With the release of Aviva Investors’ House View Q2 2023, Jennie Byun (JB) puts the questions to Michael Grady (MG) on our latest economic and asset allocation views.
JB: Let’s start with the key story – volatility stemming from the banking sector. This has hit the US and Europe with the demise of Silicon Valley Bank and Credit Suisse. Do we need to be concerned about contagion across the sector and into the wider economy?
MG: Following a decade or more of near-zero interest rates and quantitative easing, it should not come as a great surprise some were unprepared for a higher rates environment. But while there will be specific entities that fail, and undoubtedly more debt problems, we remain of the view overall non-financial private sector balance sheets are robust. Financial sector balance sheets are also far more robust than in the lead-up to the global financial crisis (GFC), with regulators requiring much greater capital and liquidity buffers.
However, confidence can evaporate quickly, and, in a world of digital banking, deposits can run much more easily than in the past. We remain cautious in the near term, with financial stability risks front of mind. We expect central banks to use the full range of tools available to manage further liquidity issues.
JB: How does this change the inflation outlook?
MG: With oil and gas prices easing, alongside significant government subsidies for natural gas in Europe, the peak in headline inflation looks to be well behind us. While the developments in headline inflation are encouraging, the same can’t be said for underlying or core measures. These remain uncomfortably high and sticky at around six per cent across major economies. Wage growth also remains elevated, reflecting extremely tight labour markets.
We expect the period of weaker growth and shallow recession to ease pressures in the labour market
Looking ahead, we expect the period of weaker growth and shallow recession to ease pressures in the labour market, with unemployment expected to rise, and therefore to ease wage growth. That should reduce inflationary pressures and is expected to coincide with a decline in margins. As such, we expect underlying inflation to ease back throughout 2023 and 2024, albeit sluggishly, towards two per cent.
However, there is uncertainty around that outlook, with the potential for near-term pressures from wage growth and a modest rebound in global goods price inflation as Chinese demand rises. Further out, the risks look more balanced.
JB: Markets are pricing in interest rate cuts in the second half of this year – do you agree?
MG: The economic and financial market uncertainty created by recent events in the banking system is expected to leave central banks more watchful in the coming months. That means the rapid rate-hiking cycles that have been running for a year or more may be paused, or even come to an end.
We have seen expected rate hikes delivered
In our year-ahead outlook published in December, we expected the Federal Reserve, European Central Bank and Bank of England to reach the peak of the tightening cycle by the end of the first quarter this year, with rates of around five, three and four per cent respectively. Now we have arrived there, we have seen those rate hikes delivered (with only the Bank of England having gone further to 4.25 per cent).
If there is no further contagion across the banking system over the next few months, we may see further rate increases around the middle of the year, as the inflation backdrop remains so challenging. We will be closely monitoring information on bank lending and surveys on credit availability in particular. If credit conditions are seen to be tightening sharply, we will be at the end of the tightening cycle and the potential for rate cuts before the end of the year will increase; however, this is not our base case scenario.
JB: How will this affect growth?
MG: Activity over the last three months has generally surprised on the upside, leading to modest improvements in the growth outlook and an increasing hope that even shallow recessions might be avoided. However, while it is too early to have any clear view on the impact of the regional banking issues in the US and the demise of Credit Suisse in Europe, there is potential for a greater tightening in credit conditions than expected.
Overall, our global growth projections for 2023 are 2.75 per cent, with a similar rate expected in 2024. We see the risks to this outlook as tilted to the downside.
One area of concern for US mid-sized banks could be commercial real estate exposure, which has grown significantly over recent years. Second, the war in Ukraine continues, with a new offensive likely in spring, which could again impact energy prices, especially the global liquefied natural gas market, which will see Europe and Asia competing for flows. Finally, we can’t rule out the possibility of a more severe bout of financial stress, particularly if confidence in individual banks or the global banking system weakens further.
The main upside risk to growth could come from a re-energised China. While the property sector is expected to remain moribund, pent-up demand for household spending, especially on services, may see growth comfortably beat the announced target of five per cent.
JB: How much does fiscal policy play into the growth and inflation narrative?
MG: Fiscal policy was already coming back into favour in the years before COVID-19. The unprecedented fiscal assistance required and provided during the pandemic, followed by many major government responses to the energy shock, have added significantly to that momentum.
Alongside a more broad-minded approach to acceptable or “prudent” deficit and debt benchmarks, this has led to growing acceptance that more activist fiscal initiatives are useful and appropriate policy tools. This does not mean such expansionist policies can be pursued indiscriminately, but it does mean any assessment of the macroeconomic outlook must take more explicit account of fiscal as well as monetary policy.
Companies and households expect active fiscal measures to be a permanent feature in this environment
Companies (including financial institutions) and households now expect active fiscal measures to be a permanent feature in this environment. The latest important examples of this are the Inflation Reduction Act (IRA) in the US and European responses to that – several of which are still being formulated. Higher military spending is also set to add to the perception of more fiscal intervention becoming the norm, including in Japan and Germany.
There are many strands to the IRA, but those relating to subsidies for clean energy are getting most attention. While laudable in principle, there are dangers frictions to trade flows are introduced (some deliberately – think China) and that competitiveness is reduced with rising protectionism.
JB: Has the changing environment affected our asset allocation views?
MG: The macro backdrop is one we expect will result in continued financial market volatility. Uncertainty at turning points is always elevated, but the nature of this cycle is unique, extremely fast-paced and everchanging. We have no misgivings about not having any high-conviction tactical or structural asset class views, apart from keeping cash levels high, until the cyclical and structural changes underway become clearer.
Equities and credit have repriced through 2022, but not to compellingly cheap levels
Equities and credit have repriced through 2022, but not to compellingly cheap levels, especially ahead of a recession. Financial strains might eventually precipitate rate cuts, but for now inflation is keeping policymakers hawkish. Some cuts are already priced in, keeping us neutral on government bonds as well – though yields may push higher in Japan and core Europe.
We are broadly neutral on the dollar, but the growth slowdown may still prove a challenge for emerging market currencies; a more dovish BoE meanwhile could weaken sterling, even as it helps UK equities and gilts outperform.
JB: It’s more than a year since Russia’s invasion of Ukraine. While attention hasn’t completely faded, headlines are receding. Oil prices have come down significantly since the peak last year. What are the considerations investors should bear in mind looking forward?
MG: There is a danger the capacity of a major event to shock diminishes over time. But that conflict is ongoing and does not seem to be near any kind of resolution. There is every chance spring offensives, by either Russia or Ukraine, or both, change the landscape again in the coming months.
The war has focused attention on energy security in the short term
The war has focused attention on energy security in the short term and led to sharply lower dependence of large parts of Europe on Russian supplies in an impressively short space of time. That, combined with the mild winter, has meant shortages have been rare and rationing has not been necessary. Prices have dropped significantly as a result, although they remain high by historical standards. The conflict also led to spikes in several other commodity prices, all of which have retreated since.
In the short term, scrambling for alternative energy supplies led to renewed use of fossil fuels to fill the gap. But over the longer term, the reverse is likely to be true, with the Russian invasion acting as a catalyst for the energy transition and decarbonisation.
View the latest version of the House View here.
