Central banks yet to win battle against inflation, interest rate hikes likely to continue


Michael Grady

Global economic activity has proved stronger than seemed likely at the start of the year, given the scale of supply-side shocks that had fuelled inflation and eaten into disposable incomes over the previous 12 months. Several indicators suggest growth accelerated in the first half of 2023 as a drop in energy prices lowered headline inflation.

However, Aviva Investors, the asset manager of Aviva plc, believes that the current economic cycle is likely nearing its end. Even though energy prices have fallen sharply, leading central banks have not yet won their battle to control underlying inflation. That suggests interest rates will continue to rise.

This ‘late-cycle’ environment could persist for a while longer, should the global economy continue to defy expectations with its unexpected resilience. All the same, major developed economies still look set for below-trend growth in the second half as the impact on household finances of higher rates saps spending.

Central banks are striving to tighten monetary policy sufficiently to weaken labour markets, deliver softer wage growth and ultimately lower core inflation without causing an economic downturn. However, it is important to recognise such periods usually end with too much policy tightening and recession.

Michael Grady, head of investment strategy and chief economist at Aviva Investors, said: “Returning inflation to central banks’ targets in a way that minimises economic damage is proving challenging, although some progress is being made. It still remains to be seen how much pain will be required to get inflation back to targets of around two per cent. But policymakers are mandated to deliver low inflation and they need to stay the course, even if that means parts of the economy suffer.

“Most equity markets have risen by between ten and twenty per cent this year as investors have sensed that interest rates were close to peaking, and that global economic growth was holding up better than expected. Company earnings, which have tended to surpass expectations, have also helped demand. In the short-term, we are optimistic on equity markets’ prospects, particularly in Europe as earnings are expected to hold up better and valuations are more attractive. But we are more cautious further ahead given the risk of recessions.

“The outlook for government bond markets looks more favourable than three months ago given the extent to which further interest rate increases have been priced in. The obvious, and increasing, danger that higher rates eventually tip economies into recession means we are now overweight the asset class. We see potential opportunities in the US since US interest rates are probably closer to peaking, while UK gilts are in a similar position given a further aggressive hike in interest rates is priced in. Emerging-market debt, denominated in local currencies, may also offer opportunities given the likelihood some central banks will start cutting rates in the second half.

“We are neutral on corporate bonds. The extra yield relative to government debt looks fair given healthy corporate profits and low default rates. But expectations a recession will be averted has led investors to bid up the price of corporate debt.

“We remain overweight cash. Although real rates of interest are negative, there is a prospect of earning a positive rate of return in the not-too-distant future as inflation falls and central banks continue to raise rates.”

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