Jeremy Batstone-Carr, European Strategist, Raymond James Investment Services Ltd*
Stock and government bond markets are sending differing signals regarding the outlook, reconciling this divergence will drive asset performance in 2023.
The combination of persistent inflation and aggressive interest rate hikes are thought likely to induce a recession across Western economies outside the U.S., albeit relatively shallow.
Inflationary pressures should dissipate as 2023 progresses, allowing central banks the latitude to pause interest rate hikes and eventually pivot lower, albeit that the latter’s timing will likely vary by geography.
The ensuing economic recovery is likely to be rapid, assisted in due course by central bank policy easing.
Although residual headwinds may limit near-term progress, as 2023 unfolds so government bond yields should fall, closing the year lower than end-2022 levels. After a mixed start to the year, stock market upside momentum should build in the months ahead and on into 2024.
Boosted by a slight lessening in the headwinds ever present throughout 2022, developed market equities staged a strong revival as the northern hemisphere autumn slipped into winter. U.S. stocks rallied but still underperformed their European counterparts in common currency terms as exchange rate effects associated with a reversal in the U.S. dollar’s earlier strength played a major role in performance. The stock market rebound is at odds with the inversion in the sovereign bond yield curve. Not only is the Treasury curve significantly inverted, but the global government bond curve in the closely watched 2-year / 10-year segment has done the same. The message from the developed bond market is that the global economy is sliding into a recession. Recent stock market gains may fade as the slowdown advances, but they should recover from mid-2023.
The Global Economy will suffer its lowest growth rate in four decades in 2023
Persistently high inflation and the monetary policy response are driving the global economy into recession. The coming global weakness will see sluggish growth or even outright GDP contractions in most developed economies outside the United States, with the eurozone likely to fare worst. Whilst comparisons are likely to be made between the pandemic-induced recession of 2020 or the Great Financial Crisis period, adjusting for changes in trend growth, the depth of the coming downturn is more likely to resemble that of the 1990s than anything more recent.
A comparatively shallow recession is our base case scenario for early 2023, followed by a relatively swift recovery thereafter. There is, however, no room for complacency; the risks are skewed towards a deeper and more protracted downturn.
It will be the developed economies that will deliver the largest peak-to-trough falls in real GDP, with the U.K. and Europe hit disproportionately hard. But this is an unusual economic cycle and very unlike those of the recent past. Potential GDP growth has slowed over time, and a given fall or slowdown in GDP growth will thus have differing implications for the degree of spare capacity in an economy (or the size of the output gap) and, by extension, inflation and the policy response.
Global inflation will dissipate in 2023
Inflationary pressures are thought likely to dissipate as 2023 progresses, especially so at the headline level, as commodity prices, ex-energy, continue their slide in response to weak global demand. Underlying inflation may prove more “sticky”, but any diminution should encourage systemic central banks to slow the pace of monetary policy tightening, then pause and ultimately pivot lower. There will, however, be significant geographical variance in both the timing and nature of the eventual pivot. The European Central Bank is thought unlikely to cut regional rates at all over 2023 and while the proposed fiscal tightening may limit the scope for aggressive rate hikes in the U.K., underlying price pressures are unlikely to encourage the Bank of England into an easier policy stance until the back end of next year.
What does this mean for financial markets?
Despite the subdued outlook for the global economy, pros-pects for financial assets look brighter than they did heading into 2022. Developed economy sovereign bond markets are expected to rally as 2023 progresses, inflationary pressures fade and central banks slowly transition to an easier policy stance. This trend is expected to be most apparent in Canada, Australia and New Zealand, where yields are expected to decline comparatively sharply.
In contrast, government bond yields in the eurozone, whilst likely to end 2023 lower than they began the year, will face the twin headwinds created by persistent residual underlying inflation and a regional central bank further behind in the policy tightening cycle than its developed economy peers. On the flip side, the establishment of an “anti-fragmentation” policy instrument, allowing for targeted intervention where necessary, should limit the scope for peripheral yield spreads to widen or markets to become disorderly. The outlook for U.K. gilt-edged securities has improved following a return to fiscal policy orthodoxy after an unwelcome interlude earlier in the autumn. Here too, yields should fall from prevailing levels as risk premia fade. Political uncertainty, although diminished, has not gone away completely. The Conservative administration is trailing the leading opposition parties by a wide margin in opinion polls, and an election must be held before early 2025.
Developed market equities
Despite the welcome rebound across developed global equity markets, we enter 2023 defensively positioned with a preference for specific themes (renewable energy, energy infrastructure rebuild) and for sectors and stocks thought more resilient to the economic cycle.
The reason for this is that investors’ earnings expectations, despite a falling trend, are still too optimistic, given the subdued global economic backdrop. A global economic recession, albeit shallower than those of the recent past, will weigh on the more economically sensitive sectors, and thus we anticipate that lowered expectations for both the corporate top and bottom lines will act as a significant headwind, at least over the first half of 2023.
Admittedly, any central bank pivot could place downward pressure on real yields and prove supportive to equity valuations. But whilst limiting overly aggressive downside, history confirms that valuations have tended to fall at the onset of a recession as the deterioration in risk appetite more than outweighs the offsetting impact of any decline in safer asset yields. However, equity markets are discounting assets and inhabit the future as much as being informed by the present. As 2023 progresses and the dark clouds shrouding the global economy begin to disperse, we expect the outlook to become more constructive for risk assets.
Benchmark equity indices should stage a decent rally into end-2023 and build on those gains into 2024.