As we move into 2023, the global economy continues to face a confluence of challenges. From persistently high inflation and aggressive global policy tightening (led by the US Federal Reserve (Fed)) to the continued fallout of the Russia-Ukraine war and the energy crisis, weak consumer confidence and political disruptions, our base case remains a hard landing. Through the last quarter of 2022, our proprietary activity trackers have indicated a continuing slowdown, with a recession likely in the US and near certain in Europe and the UK.
In the US, the Fed appears set on raising rates significantly beyond neutral levels to bring inflation under control. We do not expect a pivot until there is a meaningful deterioration in hard data, especially inflation and the labour market. The US housing market is already showing signs of stress, as higher mortgage rates and reduced affordability stifle transactions. However, inflation and the labour market are still strong, compelling the Fed to keep going, given their focus on current spot data against the backdrop of underestimating inflationary pressures last year.
At this juncture, one important concern is that the Fed is too focused on backward looking data, especially in relation to the labour market. By the time that shows signs of weakness, it may already be too late for the US economy. Real rates have been positive for some time and in some parts of the yield curve pushing towards pre-Global Financial Crisis (GFC) levels. We have repeatedly argued that the financial system cannot take positive real rates for any material length of time (due to high levels of debt) before financial stability becomes an issue. Given liquidity and assets are already under considerable pressure, the system could start to crack. There is a risk that if the Fed stays true to its current word and doesn’t stop until inflation is back near 2 per cent, a “standard” recession could turn into something worse.
We will be watching for signs that the Fed and other key central banks are wise to this possibility and other risks, potentially easing off tightening in some cases until the impact of previous tightening is clearer.
Alongside central banks, governments will have an important role to play in driving macroeconomic prospects for 2023. As we’ve seen in 2022 from the market gyrations caused by UK fiscal policy and political uncertainty, combinations of monetary tightening and mis-judged fiscal decisions have the potential to turn into financial stability risks. Indeed, the UK is not the only economy confronting fiscal and monetary policy challenges simultaneously, so it may prove a canary in the coal mine.
We will be watching for signs that the Fed and other key central banks are wise to this possibility and other risks, potentially easing off tightening in some cases until the impact of previous tightening is clearer. In any case, inflation is likely to moderate, but we expect it will do so gradually. Indeed, structural trends such as decarbonisation, deglobalisation, and the process of dealing with high debt levels are likely to keep up the inflationary pressure over the coming years.
This could limit central banks’ ability to support growth with monetary stimulus, marking a regime change from the disinflationary post-GFC era when real interest rates (interest rates adjusted for inflation) were consistently driven further into negative territory to support growth. As noted above, the market reaction to the UK government’s recent fiscal expansion plans demonstrates the difficulties that policymakers around the world could face when seeking to support growth while simultaneously controlling inflation.
Europe has its own set of problems to deal with. Its 2023 will be decided by the direction of energy prices, the nature of fiscal support provided to consumers, and the weather. A warmer winter will reduce the chance of gas rationing or blackouts due to lack of supply (early indications are that this might be the case based on Europe’s Weather Centre (ECMWF) and UK Met Office forecasts, which is good news). Alongside the continued tragic human cost of the Russia-Ukraine war, energy security will remain top of the agenda for Europe and the UK, which could be a significant driver of capital in the future.
Another significant determinant of 2023’s economic picture will be China. There are tentative signs that strict anti-Covid measures will be relaxed (though slower than expected), which would be positive for economic growth, and we expect monetary and fiscal policy to stay loose (and be loosened further), putting a floor under economic developments which have been under severe pressure. Uncertainty about the future of renminbi price trends persists; we believe the PBoC is willing to accept some depreciation to support export growth especially given relatively low inflation. In the wake of the 20th Communist Party Congress, we will be watching closely to see the potential policy feed-through in areas ranging from digitisation, national security and the focus on self-reliance to the opening up of capital markets, while keeping a close eye on the tense US-China relationship.
What does all this mean for investors? While the macroeconomic outlook for 2023 makes for disconcerting reading, it is important to remember that markets rarely follow economics in straight lines and the appearance of ‘value’ across asset classes (especially in fixed income and some parts of equity markets) will be an important trend to assess alongside macro developments.
