Inflation was a dominant theme impacting investors in 2022. It will continue to be important in 2023, dictating the future path of interest rates, the broader market environment and the cost of living. But are there signs that inflation is beginning to moderate? What is the data showing us, and what may investors expect to see in the months ahead?
Welcome to the first blog in a new series taking a deeper look at our eight key investment themes for the year.
Why is inflation so high?
Last year, inflation hit highs not seen in decades. Supply chain issues, the war in Ukraine, and easy central bank policy prompted a rise in energy, food, and house prices, with rising wages and tight labour markets adding to inflationary pressures.
Combined, these factors represented a strong price shock that is still passing through the global system. The rising cost of groceries was particularly noticeable, as many of us doing the weekly food shop will have realised (see Chart 1 below).
Chart 1: UK and US food inflation (%) 2010-2022
Source: Nutmeg, Macrobond, January 2023
Has inflation peaked?
On a broad basis, it appears that inflation around the world is beginning to moderate. In the last few months, supply chain issues have improved and wholesale energy prices have fallen. The recovery and normalisation of the global supply chain and a drop in upstream price pressures should support businesses by reducing their input costs, making conditions easier for some.
During 2022, central banks had to remove their easy policy stance and implement a rapid series of interest rate rises. It takes time for economies to feel the effects of higher interest rates, and we’re beginning to see their impact in the data. It’s early days, but these factors seem to be helping lower the headline figures for inflation in some of the world’s developed economies.
Will inflation and the cost of living go down in 2023?
Inflation and the cost of living should continue to moderate as we head further into 2023. However, the pace at which it recedes will depend on two factors.
The first is wage growth, particularly in developed markets. ‘Tight’ labour markets (where unemployment is low and there are many vacancies) keep wages high, which can add to inflationary pressures and perpetuate the expectation that inflation will remain high or continue to rise.
Chart 2. UK and US wage inflation rate (%) 2010-2022
Source: Nutmeg, Macrobond, January 2023
The second is the reopening of China. While, in some areas of the global economy, activity is slowing and the headline rate of inflation is cooling, the picture may change as the Chinese economy continues to reopen. The price of commodities, raw materials and goods may start to rise if the country and its manufacturing presence returns to a period of strength and growth.
Chart 3: Industrial metal prices vs Chinese GDP (basis points) 2010-2022
Source: Nutmeg, Macrobond, January 2023, 100 basis points = 1%
Will central banks keep raising interest rates?
When thinking about future interest rate rises, central banks look at core CPI data. Within core inflation, there are ‘sticky’ and ‘flexible’ elements. Sticky inflation is often the slowest and hardest to change.
If we look at current inflation data in these terms, we’re seeing that some elements of non-core inflation are falling, while some elements of core inflation are still rising. The ‘stickiest’ elements of core inflation are services and wages. So, in some areas of the economy, underlying price pressures remain strong.
This means that, in the months ahead, central banks are likely to continue raising interest rates to try and bring sticky inflation down. They’ll want to see a sustained moderation in core inflation before they start cutting interest rates.
However, they don’t want to go too far and engineer a recession. They want to temper economic growth so that inflation can ‘leak’ out of the system. Critical to this will be the lowering of services inflation, as services form the largest part of many modern economies and therefore influences the overall level of inflation.
So, in summary, central banks will be looking closely at services and wage outcomes in 2023 as a guide for how far they will need to raise interest rates.
What does this mean for the Nutmeg portfolios?
Here at Nutmeg, we’ve positioned our managed portfolios for the months ahead to reflect our current perspective on the macroeconomic and market environment.
We think central banks will succeed in bringing inflation down without causing too steep an economic decline. But, since their policy aim is to restrict economic growth by raising interest rates, we maintain a small underweight to both equity and government bonds.
We are overweight corporate bonds to offset the equity underweight, and we are overweight emerging market equities which we think stand to benefit from the ‘opening-up rebound’ we’ve already seen in developed economies.
You can find out more about the latest changes we’ve made to the fully managed and socially responsible portfolios in this blog.
Next time, we’ll focus on the next theme in our outlook for 2023 – bonds. To read the outlook in full, click here.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.