Financial markets were severely challenged during 2022 as central banks moved decisively to control inflation not seen since the 1980’s. The decline in equity and bond pricing at the same time is most unusual and can be sourced back to the unrealistic and excessive asset pricing that resulted from the central bank interest rate and stimulus policy over the last decade.
Following the experience during the 1970’s and 1980’s central banks appear to have developed a strong desire to move quickly and aggressively on inflation. As such, the speed and degree of rate hikes has been staggering, however, it would be fair to suggest the degree of stimulus and the extended period of the zero-rate policy was excessive.
The issues facing financial markets in 2023 are complex and we see a wide range of potential outcomes which creates significant uncertainty and the potential for increased volatility. Equity markets have rallied during late 2022 in the face of a potential global recession.
Two camps have developed regarding views whether the Federal Reserve will maintain on a tightening policy or pivot to a softer stance and what the triggers may be. It certainly looks doubtful that the factors that propelled investment markets during the last decade will do so over the next decade. With this degree of uncertainty, we continue to favour a more defensive approach until clarity surfaces when opportunities are likely to present.
We consider that 2023 could be a tricky year, with a high degree of uncertainty and a wide range of potential outcomes for asset classes and regions. We expect many economies to enter a recession, as the impact of higher interest rates though 2022 is fully felt. It makes more sense to maintain the defensive approach with an overweight cash position being appropriate in such times of uncertainty, and then adjust into clarity.
The markets are currently influenced by quite complex issues, largely driven by inflation control and several significant geo-political factors.
The outcome for inflation is a major factor that will affect consumer wealth and spending, company earnings, and the overall cost of doing business. These issues will influence the likelihood of recession, or not.
Inflation and Growth
We expect 2023 to feature a recession across major developed economies. There are a number of reasons we hold this view.
Monetary policy has tightened considerably, which historically has been the most common cause of a recession. We have begun to see the effects of this tightening wash through economies, particularly in interest rate sensitive sectors such as housing.
High inflation has eroded real household incomes, which will flow through to consumer spending. The US household savings rate fell to a multidecade low last month.
China, the world’s second largest economy, is unlikely to be a material engine of growth next year, even if it relaxes its approach to Covid (which we think it will), given systemic weakness in the housing market.
We also expect inflation to fall over the year ahead, which complicates the picture for markets. The forecast moderation in inflation reflects falling goods prices as Covid related supply shortages are eased and retailers find themselves overstocked in the face of weaker consumer spending. Housing related inflation should ease as house prices fall and the unemployment rate rises. The services side of inflation will be stickier, reliant on a rise in the unemployment rate and lower wages growth to ease pressure. Nevertheless, the net of the mix should see lower inflation.
How markets digest this will depend on the extent of economic and earnings growth weakness. As long as inflation moderates but growth remains robust (either because we are wrong about a recession or it takes longer for the downturn to eventuate), equity markets should respond positively (as they have done so far this quarter).
More Rate Hikes?
The market is pricing a little more policy tightening by central banks in the first half of 2023, then either unchanged rates or minor cuts in the second half of the year. This is broadly consistent with our expectations, though with some nuance. For the Fed, assuming rates rise to around 5%, this would be the largest tightening cycle since the 1980s. Prior to the Financial Crisis, the Fed took rates from 1% to 5.25% between mid-2004 and mid-2006. This time around, the market is pricing the Fed to do a little bit more (starting from 0%-0.25% rates) in half the time.
Source: Refinitiv, Drummond Capital Partners
Generally, the market’s relative expectation for policy tightening across countries reflects their sensitivity to debt (proxied in the chart above by household debt to GDP). Countries with very high debt levels, such as Canada and Australia, have lower expected terminal interest rates. Europe and Japan are exceptions to this, where moribund potential economic growth means even minor tightening has a very large impact. There is some risk that the Fed in the US will have to take rates higher than markets expect as households’ sensitivity to interest rates is lower than other major economies given the prevalence of long-term fixed rate mortgages.
Overall, these market expectations seem reasonable to us, the key point being that the bulk of the work in terms of lifting interest rates will have been done this year. We think large scale rate cuts next year are unlikely. Though trending down, inflation is still likely to be elevated and central banks will want to be sure they have tamed the inflation beast before again easing policy.
China Changes Policy Tack
A change in policy regime in China has already begun and we think the process will continue into next year. These changes relate specifically to the housing market and Covid. With respect to the former, many of the policies which were put in place in recent years to stem excessive lending and risk have been wound back or paused. Turning off the leverage taps to property developers evidently caused too much damage for policy makers to stomach given the huge importance of the sector to the overall economy. The Government has tried to offset the drag from housing using broad policy easing tools, but they have so far been unable to engineer a recovery in growth. This may have something to do with the second element of policy change – walking back Dynamic Zero Covid. Prior to the 20th National Party Congress in October this year, China was unrelenting in its approach to quelling any Covid outbreak via harsh lockdowns and Orwellian population surveillance.
Since then, there have been a number of steps taken to walk back that approach. The Central Government outlined 20 Optimisation Measures which cut quarantine requirements and contact tracing among many other things. The Government has also placed some of the blame for harsh lockdowns on local Governments. In response, cities and provinces have also reduced restrictions, ambitious targets have been set for vaccinating the elderly and Government propaganda publications have been producing content downplaying the severity of the Omicron variant. With cases still rising sharply, we expect the winding back of Covid restrictions to continue early in the new year, paving the way for a full reopening. While this will potentially allow stimulus measures to support growth through the year, we think the market is understating the overarching weakness in the housing market, which will prevent an economic recovery of the nature seen in previous stimulus cycles.
The above outlook is relatively close to current market consensus, though we would argue that consensus moved towards our longer held view rather than the other way around. Importantly, there are a number of ways the global economy could pivot, spoiling the outlook.
Rates Keep Rising – An interesting alternative scenario is one where the interest rate hikes expected by the market are insufficient to combat inflation. The US is most at risk of this outcome, as household balance sheets remain much stronger than they were prior to the Financial Crisis and underlying economic growth is very strong. Inflation is also much higher and more entrenched than in any other tightening cycle post 1990. In early 1980, the Fed needed to increase interest rates by around ten percentage points to combat inflation. The RBA increased interest rates by around 7.5 percentage points in the late 1980s. Rate rises of this magnitude would mean a much larger recession and much lower asset prices.
China Falls Over – 2023 might finally be the year that China’s economic growth model comes unstuck. Many years of debt accumulation used to fund unproductive assets has lowered potential economic growth, but has kept the population employed and boosted headline GDP numbers. With deep weakness in the housing market less responsive to policy stimulus this year and Covid overhanging the economy, next year may be the one in which China’s long-awaited shift into a Japan style lost decade finally happens.
Asset Prices Collapse – The impact of very low interest rates in the decade following the financial crisis has been higher asset prices almost everywhere. Asset valuation models directly translate lower long term government bond yields into higher net present values for individual stocks, commercial real estate and infrastructure. Households feel they can afford to take on more debt when servicing costs are low, increasing the price of housing. To date, the fall in global asset prices has been much smaller than the increase in long term interest rates we have seen would imply. The longer that interest rates remain elevated, the bigger the risk that global asset prices continue to fall.
Government Debt Matters Again – The US Government will more than likely face issues raising the debt limit again next year given a Republican House of Representatives and Democrat President. This is likely to cause some market volatility as negotiations become hostile and Government shutdowns and defaults are back on the agenda. Likewise, there is a good chance that the sustainability of Italian debt dynamics is questioned, given higher interest rates make financing that debt burden incredibly difficult. Perhaps even questions are finally raised around Japanese Government debt, should the Bank of Japan be forced to raise interest rates.
Acknowledging that one year forecast asset class returns are fraught with danger and will almost certainly be incorrect, we still think it is instructive to demonstrate how our forward view of the investment environment may translate into asset class returns if we are entirely correct. Overall, we expect reasonable returns to cash and bonds, reflecting this year’s rise in interest rates. For longer dated bonds, downward pressure on yields from lower growth and inflation expectations should be broadly offset by still high shorter term interest rates, meaning we do not expect a wholesale change in capital values until central banks start cutting cash rates. However, the increase in yields means the carry earnt from bonds is much better than has been the case over the past decade.
Credit and equity returns are expected to be negative, reflecting a forthcoming recession. Australian equities are expected to outperform global equities reflecting their more defensive characteristics. Our previous analysis suggests that equity markets do not bottom during a recession until inflation has peaked and central banks are well into a policy easing cycle. In a normal environment, the lags between monetary tightening and economic growth suggest this year’s rate hikes will begin to be meaningfully felt from the middle of next year. This suggests a recession begins middle to late 2023 with interest rates to be cut late 2023 or early 2024. There are some caveats to the above. Europe is likely already in recession given the energy price shock. Australia may enter a recession later given the RBA has lagged other central banks in hiking rates (and may even get lucky again and avoid one if history is any guide). Strong consumer balance sheets in the US may see households hold out a little longer than normal before capitulating and reducing spending, which may delay a recession there until early 2024. Rate cuts may be delayed if inflation does not fall as much as hoped. All of the above suggests to us the equity markets will not find a bottom in the first half of next year and moderately low forecast expected returns for 2023 likely feature a first half downturn and some recovery late in the year.
Returns to alternatives should be generally insulated from this pain (given their generally market neutral nature). REITs and infrastructure relative returns are influenced by relative starting valuations. Infrastructure has outperformed over the year, but the underlying companies are still sensitive to economic activity and falling commodity prices. REITs have been badly punished following Covid drawdowns and then higher interest rates, with the impact of the latter arguably already having washed through the asset class.
Source: Drummond Capital Partners
Prepared in conjunction with our external investment consultants Drummond Capital Partners (Drummond) ABN 15 622 660 182, AFSL 534213 and WP Invest ABN 55 111 685 226, AFSL 301210. It is exclusively for use for Symmetry clients and should not be relied on for any other person. Any advice or information contained in this report is limited to General Advice only.
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