A consensus is emerging among market participants that recession this year will lead to a sharp fall in inflation, but investors should be concerned that inflation could linger on, according to Jeremy Lawson, chief economist at Abrdn.
Of the outlook for the global economy he said: “The global economy is on the precipice of recession. Indeed, recessions appear to have already begun in some economies."
He pointed to leading indicators in the Eurozone, which are deep in contraction, and said as a result, he expected GDP growth to turn negative from the fourth quarter of 2022.
Lawson said: "Admittedly, energy rationing this winter now looks less likely, given the build-up in gas storage. But the mild weather and reduced Asian demand that have allowed Europe to secure large amounts of liquid natural gas cannot be relied upon to continue.
"Moreover, we see no immediate end to the Russia-Ukraine war, meaning no flows of pipeline gas. In any case, avoiding gas rationing this winter only makes Europe’s recession less severe, rather than preventing it."
He added that while the UK economy contracted in the third quarter of 2022, he expected a more “fundamental” recession, rather than just a technical one, is on the way, while was is also cautious on the outlook for the US.
Capital protection
Times of deep recession would typically lead to investors focusing on capital protection, something which is easier to achieve if inflation is low, as the spending power of the capital is not denuded by inflation.
But Lawson said one of the range of outcomes investors need to prepare for is higher inflation and a recession, which would make capital preservation a mite more difficult.
He explained: “Global headline inflation pressures are passing their peak. But core inflation will prove stickier, as labour markets are too tight and firms have too much pricing power..
"Risks are skewed towards weaker growth but higher inflation than the consensus expects. We have introduced a “sticky inflation” scenario in which tightening triggers recession, but underlying inflation proves more persistent.”
All of this has made him cautious on the outlook for markets, as he feels both equity and bond markets are now both pricing in a more benign economic outlook than he thinks will be the reality.
Kevin Boscher, chief investment officer at Ravenscroft, is another who said he believed inflation would remain “higher and more volatile”, than many currently expect, but said bonds could still perform well.
Fixed returns
According to Boscher, at current valuation levels, bonds are already pricing in higher inflation, and therefore, he said it was time to "selectively increase exposure to fixed income and extend duration".
He explained: "Bonds have suffered their worst drawdown in over a century and now offer attractive valuations, even if inflation falls slower than expected and rates subsequently stay higher for longer.
"In other words, bonds have likely discounted all of the bad news about inflation and will benefit from the Fed, ECB and BoE turning increasingly dovish as they battle a recession or major growth slump next year.
