BNY Mellon’s Dhar: Bank of England faced with ‘most difficult task’ in countering stagflation

Chief economist says recession risks are higher than markets are pricing in

Shamik Dhar, BNY Mellon
Shamik Dhar


BNY Mellon chief economist Shamik Dhar (pictured) said interest rates may have to go up further than markets currently expect, with the Bank of England facing the ‘most difficult task’ in countering stagflation.  

Dhar, who leads the Global Economic and Investment Analysis (GEIA) team, observed in the firm’s latest Vantage Point report for Q4 that the likely recession could be a ‘slower burn’ for Europe.

The report noted that Germany is likely to see three consecutive quarters of falling output, which Dhar said is evidence that Europe is slowing much more rapidly than the US.

“Core inflation remains worryingly high and labour markets look tight. Inflation expectations remain above target and it still looks like we may need a bit more monetary tightening to get us back to 2%,” Dhar said.

“The euro area and UK are clearly weakening sharply, but real wage resistance is high in those two economies, so central bank rhetoric remains hawkish and will probably remain so until there is clear evidence inflationary psychology has been punctured.

“The situation is slightly different in the US – economic activity continues to surprise to the upside, with household spending proving robust – but inflation has surprised to the downside for much of this year and could plausibly get back to target without much more intervention from the Fed.”

See also: To cut or not to cut: Are markets in for a ‘pleasant surprise’ from central banks?

The GEIA team is anticipating an unavoidable recession in both the US and Europe, placing its likelihood at 50%. However, the analysts noted that the likelihood of a soft landing in the US is growing.

Meanwhile, UK inflation still remains way above the Bank of England’s 2% target despite easing 40bps to 6.7% in August.

Dhar added: “The UK stands out as having the worst of the US and European issues – both the large energy price increase and a large reduction in effective labour supply.

“As a result, the ‘stagflationary’ shock has been worse in the UK than anywhere else and, as references to the ‘cost of living crisis’ continue to dominate headlines, inflationary psychology has developed furthest there and leaves the BoE with the most difficult task in countering it.”

See also: A year on from the mini-budget, has investor confidence in the UK been restored?

Asset allocation

In terms of equities, the GEIA team remains cautious on increasing cyclical exposure but notes a rising possibility of a soft landing in the US.

Its outlook is considerably more positive on a multi-year horizon, particularly on US equities benefiting from AI adoption.

“Higher yields present buying opportunities, as we see extending duration as a favourable risk/reward trade-off into 2024. Given the difficulty in timing a recession and the associated market moves, we think the risk of being too late in extending duration outweigh those of being too early,” the analysts on their fixed income outlook.

“With spreads remaining tight, we lean in favour of sovereign debt and high-quality fixed income over lower quality credits that face greater spread risk.”

Finally, the firm has a ‘tactically favourable’ view on alternatives and real assets. It noted that, historically speaking, alternatives are less sensitive to growth swings so may provide additional portfolio stability during a slowdown.

Dhar concluded: “By our estimates, recession risk remains material and is higher than what the markets are pricing in. While ‘recession fatigue’ from a downturn that never seems to arrive, is understandable this fatigue is not an excuse to abandon the data and adopt an investment strategy of hope.

“Therefore, we position to get ahead of recession impacts, rather than hope for immaculate disinflation.

“The data continue to provide strong evidence that near-term recession risks are well above average, and our tactical recommendations reflect this. However, there is a note of optimism in our multi-year outlook, principally stemming from our views of AI’s growing economic impact.”

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