Let's begin by starting where we last ended.
Download PDF VersionIn our last quarterly Market Report, I stated that “the key directive seems to be a transitioning from worrying about inflation to worrying about a recession over the next 12 months. During this period, we can expect more volatility to portfolios as the markets react and find their levels in the current environment.
This sentiment is still true now, and in looking back over the great market sell-off of 2022, it was indiscriminate, wiping trillions off the stock market capitalisation of risky and not-so-risky assets and taking huge bites out of portfolios. This was the worst year for the financial markets since 2008 with tech stocks, treasury bills, bonds, cryptocurrencies, real estate, and other assets all chalking up deeply negative returns.
Investors will blame the Federal Reserve, whose job in fighting the highest inflation in four decades was complicated by Russia’s invasion of Ukraine and a commodity price shock. It was the 1980s redux for the Fed, with financial conditions tightening so much the 10-year Treasury yield increased by 2.36% over the last 12 months and the dollar appreciated to 20-year highs against most major peers.
While there are reasons to be optimistic, we might not see their impact until late in 2023 or possibly even 2024.
Reasons to be optimistic
• China - China’s ongoing challenges with Covid-19 are a major moving part, but the easing of severe lockdown policies is the only way forward.
• USA – By the end of 2023, the American economy should be climbing out of its mild recession, with inflation in retreat.
• Inflation - As the spotlight remains on whether the Fed can tame inflation without causing a recession, investors should look to recent data showing that inflation is cooling.
• Crypto - Even crypto evangelists see the silver lining in fraud and failures, staying bullish on Bitcoin.
Technical analysis suggests the bear market framework is still intact, however macro strategists will warn about any number of gathering storm clouds.
So, we can expect more turbulence in the coming months and quarters.
There is reason to think that the coming recession will be mild.
America is heading for a recession in 2023. Over the past half-century, whenever inflation has reached an annual pace of more than 5%, it has always taken a recession to wring it out of the economy (according to the Economist). The current episode of inflation will be no different. Only when growth truly goes negative will America be able to contain its rampant price pressures.
The proximate cause of the recession will be the Federal Reserve, which is set to continue tightening monetary policy in 2023. In September 2022, the median forecast of Fed officials was that they would raise interest rates to a terminal rate of 4.6% in 2023. But inflation will still be frustratingly persistent early in the new year, so the Fed announced in December that it expects to go beyond that, taking rates up to 5.1%. Financial markets, already under stress from all the rate rises in 2022, will face fresh worries as indebted companies and spendthrift households struggle to cover their elevated interest costs.
But it will not be all gloom. There is reason to think that the coming recession will be mild. Throughout the past year, the number of open jobs has far outstripped the number of available workers. The implication is that even if a growth contraction leads companies to pare back their hiring plans, they are likely to refrain from large-scale layoffs. The unemployment rate will inch up from the lows of 2022, but it will not rocket up, as has typically been the case in previous recessions.
The picture for the American economy will change markedly over the course of 2023. Disinflation will eventually take hold, turning into outright month-on-month deflation when the recession strikes. That ought to spell the end of the Fed’s rate-hike cycle by the middle of the year, with the focus instead shifting to when it might start to loosen policy. The Fed will be in no haste to make big rate cuts, having fought so hard to rein in prices. But the combination of a recession and fast-diminishing inflation should lead it to trim rates before the end of 2023, in an attempt to ease the downside pressures. By the end of 2023, the American economy should be climbing out of its mild recession, with inflation in retreat.
Hyperinflation is, fortunately, a very remote prospect.
Inflation had been low for a while. But then, in the summer of 1922, prices started to climb dramatically. A loaf of bread that had cost 0.30 German marks in 1914 was selling for 8 marks in June 1922 and 160 marks by the end of that year. What followed in Weimar Germany was hyperinflation, which led to more than just the collapse of the currency.
Exactly 100 years later, Europe is grappling again with high inflation, caused by a European war. Hyperinflation is, fortunately, a very remote prospect: the economies of Europe are strong, and policymakers are committed to keeping debt sustainable and tackling inflation.
But in 2023 the full economic impact of price rises, and the energy crunch that largely caused them, will be felt across Europe—leading first to a recession and then to a painfully slow recovery.
Energy will remain expensive. Europe has added to its import capacity for liquefied natural gas, but global supplies will not increase by much. Gas-storage facilities are almost full and, thanks to a warm autumn, will not be completely empty by spring. But oil-producing countries seem determined, despite diplomatic pressure from the West, to keep oil scarce and expensive. This will leave inflation higher than many had hoped.
Consumers and businesses will feel the brunt and start to hold back. Household budgets will face a double whammy: higher energy bills and increased mortgage payments as interest rates remain high to fight inflation. Firms will also be squeezed, and so will cut back on investment. All of this will tip Europe’s economy into recession.
Unlike in previous slumps, the global economy cannot come to Europe’s rescue. Export orders for its industry will remain low during 2023, as higher interest rates, the global energy crunch and the strong dollar weaken growth and demand throughout the world. Only once energy prices have come down, and inflation in America has been brought under control, will global growth be able to support Europe’s recovery. But that will not happen in 2023.
'Britaly' - a country of political instability, low growth, and subordination to markets.
Britain's economy is on course to shrink 0.4% next year as inflation remains high and companies put investment on hold, with gloomy implications for longer-term growth, according to the Confederation of British Industry's (CBI) forecast on 5th December. The median investment bank forecast is even gloomier at -1.0% according to data compiled by Bloomberg.
"Britain is in stagflation - with rocketing inflation, negative growth, falling productivity and business investment. Firms see potential growth opportunities but ... headwinds are causing them to pause investing in 2023," CBI Director-General Tony Danker said.
The CBI's forecast marks a sharp downgrade from its last forecast in June 2022, when it predicted growth of 1.0% for 2023, and it did not expect gross domestic product (GDP) to return to its pre-COVID level until mid-2024.
Britain has been hit hard by a surge in natural gas prices following Russia's invasion of Ukraine, as well as an incomplete labour market recovery after the COVID-19 pandemic and persistently weak investment and productivity.
As a result, the CBI stated that they expected unemployment to rise to peak at 5.0% in late 2023 and early 2024, up from 3.6% currently. British inflation hit a 41-year high of 11.1% in October, sharply squeezing consumer demand, and the CBI predicts it will be slow to fall, averaging 6.7% next year and 2.9% in 2024.
Britain has also suffered from a lack of political cohesion. Given the frequent changes of prime ministers and cabinets, The Economist even used 'Britaly' as a headline of its cover to portray today's situation in the UK, which indicates a 'country of political instability, low growth, and subordination to markets'.
The political turmoil in the UK is an embodiment of the country's confusion in the post-Brexit era. If the country cannot get out of the current bewilderment, the chaos will not ease significantly. After the 2016 Brexit referendum, British politics has entered a period of relative mess, witnessing more political instability.
Asian economies continue to stand out as arelative safe haven.
Against the challenging macro backdrop of a global economic downturn, Asian economies continue to stand out as a relative safe haven with resilient domestic fundamentals to weather the recession risks.
We believe Asian economies can maintain their relative recent outperformance against their global peers with silver linings of accelerating economic reopening and more growth-supportive policy initiatives. China’s recent pivot towards gradual relaxation of the Zero COVID policy and more comprehensive policy support for the property sector are notable drivers to support its gradual growth recovery in 2023.
We expect GDP growth in Asia (ex. Japan) to accelerate to 4.5% in 2023 from 3.9% in 2022, which is still respectable compared with many developed economies which should see close to zero growth in 2023. We believe a recovery in China’s consumption and investment, amid its gradual reopening, would boost the overall growth outlook for the region, given China is the single largest trading partner of 16 major Asian economies.
We have selected key indices as a representation of the markets rather than a substitute for the whole market as they are the most recognisable for our clients.
Both stock and bond indices retreated sharply in 2022, making it the worst year since 2008 and one of the worst calendar years on record for 60/40 portfolios. All US and European equity market (except the UK) sectors ended the year in negative territory apart from the energy sector.
All the major central banks now have a mandate to ensure that interest rates rise and fall within what are considered stable inflationary limits. In most instances this is 2% per annum, the 'goldilocks' scenario where the underlying economy is neither 'too hot nor too cold'.
Forecasts for monetary policy tightening and interest rate hikes provided by markets, investment banks and central banks have gradually increased over the course of the past year.
The quarterly 'dot plot' of FOMC (Federal Open Market Committee) policymakers’ interest rate projections published on 14th December showed that the median projection for the federal funds rate in 2023 rose to 5.1%, well above the 4.6% officials had anticipated in September 2022. This is well into restrictive territory, since the “neutral rate”, where interest rates neither support nor restrict economic growth, is estimated by the Fed to be at 2.5%.
The ECB, the BoE and the SNB (Swiss) all recently raised rates by 0.5% and warned of further rate hikes, the ECB announced that it would start tapering its balance sheet in March and the BoJ surprised markets by loosening its yield curve control policy in a move widely interpreted as marking a 'pivot'.
The only prediction you need to be right about: Which way is the market going? Will it be a bull market or will it be a bear market?
For the main part I believe 2023 it is going to be a bear. The market is extremely unlikely to be higher at year end than now, even if there is a rally at year end. Sadly, I believe the market is going down heavily, at least for most of the year, and perhaps we may see the final leg down for equities in 2023. This will be the capitulation normally seen at the end of a bear market. There might just be a recovery at year end following that fall.
The thing to keep in mind is the market is not looking today at the economic realities of now but instead it is trying to guestimate the realities about one year out. It will flip into a bull market when it sees a recovery is about a year away. That dynamic could trigger at the tail end of 2023.
Higher interest rates should also revive the appeal of fixed-income investing and boost the classic 60/40 portfolio—a strategy of allocating 60% of a portfolio’s holdings to stocks and 40% to bonds. During the past decade, many investors have lived by the motto that 'there is no alternative' to investing in stocks, or 'TINA'. With interest rates sitting near zero, the theory was that stocks were the only investment that offered a significant return—but that is no longer the case as bonds are giving you a real return for the first time in 10 years. Rising bond yields mean the classic 60/40 portfolio will make a comeback.
In short, in the near term, the backdrop for risk assets is challenging as inflation remains high, interest rates are rising, and economic growth is slowing. We expect 2023 to bring inflection points as inflation falls, central bank policy shifts from tightening to loosening, and growth bottoms. This should mean that the backdrop for investors will improve as 2023 evolves.
Real assets that historically better protect a portfolio’s purchasing power against inflation such as equities, hedge funds, commodities, real estate, and private equity should perform well and provide resilience in diversified portfolios. Also, the recent rise in yields and widening of credit spreads represents a favourable entry point for investment grade credit.
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