The economic news is likely to deteriorate. Europe and the UK are probably in recession, and a mild recession at least seems likely for the United States given the extent of monetary tightening. It’s unclear when China can fully escape zero-tolerance Covid-19 lockdowns and the property-market implosion. The exception as always is Japan, which hasn’t had monetary tightening and where the inflation spike offers the opportunity to break nearly three decades of deflationary psychology.
Markets, of course, are forward looking and usually price in bad economic outcomes ahead of time. It’s possible that we’ve already seen the worst declines in equity markets. This may be the case if the U.S. has only a mild recession in 2023. On the other hand, markets may transition from the current ‘bad news is good’ narrative that sees soft economic data as heralding a U.S. Federal Reserve (Fed) pivot, to a ‘bad news is bad’ scenario wherein fears of significant contraction in profits and jobs lead to further market downturns.
The main issue for 2023 is whether inflation pressures ease sufficiently to allow central banks to step away from rate hikes and potentially begin easing. We expect inflation will be on a downward trend as global demand slows. This should allow central banks to eventually change direction and may set the scene for the next economic upswing. Markets and economies move in cycles. There is no certainty that we have passed the worst of market conditions, but the contours of the next upswing are visible on the horizon.
United States
Inflation remains the dominant issue for U.S. markets. It pressures the Federal Reserve to prioritize price stability over the economic expansion which, in turn, casts a cloud over the outlook for corporate profits and asset prices. The duration and magnitude of the inflation overshoot has already pushed monetary policy into the danger zone. We now believe the likeliest scenario is for a U.S. recession over the next 12 months.
The good news is that private sector balance sheets are healthy, inflation expectations are more anchored than they were in the 1970s and healing global supply chains should allow volatile inflation drivers—such as durable goods inflation—to flip back toward secular deflation. These factors argue against expecting a severe economic contraction. The labour market is still overheated and correcting that imbalance will likely require some pain, such as higher unemployment as the economy cools.
Markets have partially priced in these risks, while pessimistic investor psychology argues against an overly conservative asset allocation. The equity market outlook is mixed with a tug of war between negative cyclical dynamics and oversold sentiment. U.S. Treasuries, however, look like an attractive investment, offering investors positive real yields into an economic slowdown.
Eurozone
The eurozone outlook has improved marginally, although a recession still seems unavoidable. The improvements come from the success in filling gas storage ahead of the winter, the mild weather so far and the energy savings measures implemented within the industrial sector. It now seems that energy rationing will not be required and the previous fears of forced shutdowns of energy-intensive industries should not occur. The test will come when the weather worsens and households turn up their heating, but so far, the worst fears of the energy shock are not being realized.
Eurozone inflation in October reached 10.6% in headline terms, and 5.0% excluding food and energy. It should fall during 2023 as the region’s economy weakens, potentially moving toward 2% by the end of the year. This outlook depends on energy prices stabilizing. Another surge in gas prices next year would see inflation remain high and the region in an extended recession.
More European Central Bank (ECB) tightening seems likely given the labour market pressures: the unemployment rate, at 6.6%, is the lowest since the launch of the common currency. The market expects the ECB deposit rate will peak at 2.75-3.0% by the second quarter. This seems at the upper limit of what the ECB can do given the recessionary outlook. European growth, however, should rebound in the spring. Inflation should be on a downward trend, and this should limit the amount of ECB tightening
United Kingdom
The UK seems set for a prolonged recession, as monetary tightening, fiscal tightening, the energy price shock, and supply-side constraints from Brexit combine to create a challenging outlook. GDP has yet to regain pre-COVID-19 lockdown levels, but labor-supply shortages have driven the unemployment rate to the lowest level since 1973.
New prime minister Rishi Sunak has reversed the tax cuts introduced by the short-lived Truss government and added on some tax increases. This has calmed the gilts market and reduced the pressure on mortgage rates. Markets expect the Bank of England (BOE) to lift the base rate from 3% currently to 4.5% by the second quarter of next year, as wage pressures prevent inflation from falling quickly. It’s questionable whether the BOE will be able to lift rates by this much given the direction of the economy. The BOE’s inflation vigilance, however, makes it difficult to forecast a UK recovery in 2023.
Japan
Japan is set for a year of softer economic growth in 2023. Domestic demand is weakening and there is slowing demand for Japanese exports. Unlike the rest of the world, Japan is still operating below capacity. This means it doesn’t face the risk of monetary overtightening.
Although inflation has been rising, most of it is driven by imported inflation. Japan is an energy importer and the depreciation in the currency this year has pushed up import prices.
Japan has been an outlier in developed markets this year, with the Bank of Japan (BoJ) holding steady with accommodative monetary policy. We expect monetary policy to remain unchanged until BoJ Governor Haruhiko Kuroda’s term ends in March 2023. Any adjustment in policy after that should be marginal. A growth tailwind for Japan could be a revival of the tourism sector following the depreciation in the currency and the recently reopened borders.
Japanese equites appear slightly more expensive than European and UK equities. The Japanese yen is very cheap and should benefit as global central banks reach the end of the hiking cycle and global growth starts to slow.
China
2023 should see the Chinese economy eventually exit zero-COVID government rules, after having spent most of 2022 under intense restrictions. Recent government announcements show that plans to ease restrictions are beginning to be made, but zero-COVID measures are likely to remain in place throughout winter.
A key watchpoint for 2023 is the struggling property market. The government has announced new support measures, but they do not appear large enough to create a sustained recovery. We expect more measures to improve confidence in the housing sector and to boost spending when the economy re-opens. Retail sales are running well below previous trends, driven by the zero-COVID policy and by low consumer confidence.
Attention should also be paid to any further government announcements around investment in semiconductors following the actions by the U.S. government to limit the export of chips to China.
Canada
The Canadian economy performed better than expected in 2022, but a recession seems unavoidable in 2023. The lagged effects of very tight monetary policy should soon catch up with overindebted households. Moreover, a slowing global economy will be a drag on commodity prices, challenging exports.
Although inflation has peaked, a Bank of Canada (BoC) pivot requires a discernable decline in inflation toward the upper end of its 1% to 3% range. Otherwise, policy will continue to tighten despite the slowing economy. That said, BoC Governor Tiff Macklem has indicated that the rate hiking cycle is closer to the end stages, and we believe the BoC will pause after another 50 basis points of tightening. This will take the target rate to 4.25% in early 2023. Eventually, a recession coupled with lower inflation will allow the BoC to ease policy in late 2023.
Financial markets are likely to stay volatile. The positives for investors are that bond yields are more attractive than they've been in over a decade. The Canadian benchmark bond index is yielding over 4%, the highest level since late 2008. This offers improved income and provides diversification protection for recession-driven risk-off sentiment. Canadian equities are vulnerable to a cyclical downturn, although valuations are not extreme, and medium-term prospects are supported by the supply and demand dynamics for natural resources being driven by the energy transition to low carbon sources.
Australia/New Zealand
Australia’s economy is set to slow in 2023 as the Reserve Bank of Australia (RBA) rate hikes take effect and the reopening impulse fades. Electricity prices are expected to increase by up to 80%, which will weigh on consumer spending. Inflation has likely peaked and should allow the RBA to go on pause ahead of other major central banks. We think the market expectation of nearly a 4% peak for the RBA cash rate is too aggressive. A peak between 3 and 3.5% seems more likely. A less-aggressive central bank means there is a lower risk of recession in Australia than in Europe or the United States. Australian equities are no longer trading at a discount to global equities, so the better economic outlook has, to an extent, been priced in. The Australian dollar should benefit from improving activity in China and global central banks approaching the end of their hiking cycle.
The outlook for New Zealand is more precarious than for Australia, given the aggressive rate hikes from the Reserve Bank of New Zealand (RBNZ). Housing has already suffered a significant decline, and this is likely to continue through the first half of 2023. The market expects the RBNZ cash rate to peak near 5.5%, which means over another 100 basis points of tightening. Construction activity should be supported, however, through demand from the Homes and Communities government department. New Zealand is likely to hold a general election sometime in 2023, with the election due by no later than Jan. 13, 2024. Published opinion polls point to a tight contest between the Labour Party led by Jacinta Ardern and the center-right National Party.
Source：russellinvestments
