Fading recovery prospects darken market outlook

Since our last Markets Analyst, there have been growing signs that the global economic recovery, and the UK’s recovery in particular, is built on fragile foundations that will buckle under the weight of the upcoming fiscal squeeze. If the UK’s recovery loses momentum as we expect, then the implications for the markets look set to be considerable. While the rally in equity prices has been pared back recently, the market still seems to be banking on a fairly strong recovery. But if the fiscal consolidation dampens growth by as much as we expect (we think the squeeze will knock at least 1% off GDP growth from next year), and corporate profits struggle, then equity prices may still have a little further to fall. Meanwhile, although the fiscal squeeze may necessitate tax rises which will temporarily push up inflation, the ultimate effect of the squeeze is likely to be deflationary. Markets’ inflation and interest rate expectations may therefore fall further over the coming months.