Why 2023 Will Be Different

Transcript

We think 2023 will be different in three ways as the new regime plays out.

We see a foretold recession, shifting drivers of global growth and inflation, and central banks pausing rate hikes but not coming to the rescue with rate cuts.

1) Recession foretold

Central banks’ aggressive rate hikes last year will cause recessions in developed markets this year.

2) Central bank pause

And central banks will pause their rate hikes. But despite falling inflation and recession, we won’t see rate cuts. Inflation isn’t likely to settle close to central banks 2% targets as labor shortages continue to push up wages.

3) Shifting global growth

The main driver of global growth will switch from the United States to China. Consumer spending shifting to services from goods is slowing China’s export growth. But the removal of Covid restrictions will give a boost to domestic spending.

The differences we see ahead for markets in 2023 shape our tactical investment views. We’re underweight developed market equities on recession risks, we’re neutral emerging market stocks as global growth shifts towards China. And we prefer investment-grade credit within fixed income on its attractive income and we remain underweight long-term government bonds in developed markets.

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We see three shifts shaping 2023 as the new regime keeps playing out. First, we see DM economies facing recession. Second, DM central banks will halt rate hikes when economic damage is clearer. Goods inflation should fall sharply as spending shifts. But we don’t expect rate cuts as inflation stays above policy targets. Third, China’s reopening and domestic spending will drive global growth as DM recessions hit. We like emerging market stocks over DM and like high-grade credit.

The inflation divide

Notes: The chart shows the annual change in U.S. core goods and services consumer price indexes.

In 2022, DM economies grew, China growth slowed, and inflation and interest rates surged. In 2023, sharp rate hikes aimed at pushing inflation down to policy targets will cause recessions in DMs – the first shift from last year. We’re already seeing evidence that rate hikes are hurting the most interest rate-sensitive parts of the economy, like housing. Hikes have an overall lagged effect that will reinforce economic pain from the energy shock in Europe and weigh on U.S. consumers as they exhaust savings. We think recessions will push central banks to pause hikes – the second shift. Inflation is set to fall as U.S. consumer spending rotates to services from goods, dragging down goods inflation (yellow line in the chart). But labor shortages will likely make services inflation stickier (orange line). So we don’t see central banks cutting rates to rescue DMs from recession.

Reduced U.S. labor supply means that companies are having trouble hiring. The December jobs data showed little sign of the situation changing fundamentally, in our view. Wage growth did cool, but labor shortages are still pushing it up to a level that makes achieving central banks’ 2% inflation target unlikely. Getting inflation to settle back at targets would entail reducing labor demand – and would need an even deeper recession than we see ahead. That’s why we see central banks keeping rates higher for longer than markets expect, instead of cutting rates. And over the long term, we see three structural trends keeping inflation pressures higher on average than pre-pandemic: aging demographics, geopolitical fragmentation and the transition to net-zero carbon emissions.

The third shift

China is rapidly lifting Covid-19 restrictions. We estimate its economic growth will clock in above 6% in 2023, cushioning the global slowdown as recession hits major DM economies. But China’s growth surge will be tempered by falling demand for its exports as U.S. spending shifts away from goods. We don’t expect the level of economic activity in China to return to its pre-Covid trend, even as domestic activity restarts. We see growth falling back once the restart runs its course.

Our tactical views

These three shifts we see ahead in 2023 reinforce our tactical views and are why we maintain our most defensive stance. Earnings expectations for 2023 are still not fully reflecting the DM recessions we expect, in our view. That’s why we’re underweight DM stocks. We stand ready to turn more positive on DM stocks when more of the economic damage we see ahead is in the price or our assessment of market risk sentiment improves. China replacing the U.S. as the driver of global growth underpins our preference for emerging market equities, including Chinese equities, over DM peers.

Within fixed income, we see more attractive opportunities to earn income in investment-grade credit, U.S. mortgage-backed securities and short-term Treasuries. We stay underweight long-term nominal government bonds because they don’t reflect our view that yields will rise further as investors demand more term premium, or compensation for the risk of holding them amid persistent inflation and higher rates.

Our bottom line

2022 was a year of soaring inflation, rapid rate hikes and pandemic-induced lockdowns in China. We see volatility ahead in 2023 but expect the year to be shaped by big shifts from last year: recessions in developed markets, inflation falling and central banks pausing their rate hikes, and China reopening. We’ll likely turn more positive on risk assets after gauging what’s in the price and market risk sentiment – a central theme of our new investment playbook.

Market backdrop

European equities led gains in DM stocks this week. Ten-year German bund yields led a drop in major government bond yields. Falling energy prices are helping pull down headline inflation and fanning hopes for less-hawkish DM central banks. A sharp drop in the U.S. services PMI spurred expectations for Fed rate cuts next year. But we see sticky core inflation keeping central banks on track to overtighten policy – and keep policy rates higher than markets are expecting.

We expect the annual change in the U.S. CPI to slow again in December, falling from the 40-year highs reached in 2022 as spending normalizes back to services from goods – putting pressure on goods prices – and thanks to lower energy prices. But sticky wage growth due to labor shortages is likely to keep core inflation sticky and the Fed on track to keep hiking rates.