With 2022 firmly in the rear-view mirror, investors will be hoping for a brighter year for financial markets as central banks near the peak of their monetary policy tightening cycles. Whilst we expect the coming year to be one of stalling global economic growth, we believe that financial markets have sufficiently priced in these risks, presenting active investors with opportunities across a wide range of asset-classes.
The key risk moving into the new year remains inflation, as core inflation levels remain ‘stickier’ than central banks would have expected as they aggressively raised interest rates. The last 12 months have seen the fastest increase in US interest rates since 1981, and the fastest increase EU rates since the establishment of the Eurozone. Supply chain easing and the downward pressure from food and energy declines following a year of volatility in commodity markets should allow a broad fall in inflation and potentially offer central banks a somewhat easier path for monetary policy moving forward.
All Eyes on the US
As the famous saying goes; ‘When the US economy sneezes, the world catches a cold’. This rings true today as the US Federal Reserve maintains its hawkish stance moving into the new year, weighing on expectations for a decline in global GDP growth in 2023.
The strength of the US labour market remains a key focus for the Fed, with unemployment levels unexpectedly declining in December despite expectations for unemployment to increase. Wage growth remains a key driver of inflation, with the central bank likely wanting to see an increase in unemployment before they look to cut interest rates, with confidence that inflation has been tamed.
A Tough Road Ahead for the UK and Europe
The growth prospects for the UK and Eurozone in 2023 appear subdued, reflecting the lagged effect of monetary tightening on demand alongside the ongoing drag on real incomes from higher inflation.
The risk of severe winter gas shortages across Europe appears to have been averted, with gas storage levels rising above the long-term average as the mild weather continues. Despite the recent decline, EU wholesale natural gas prices remain six times higher than pre-pandemic norms, with ongoing government support cushioning households from the impact of elevated wholesale prices. The UK recently announced the level of support currently on offer to businesses and households is to decline in April, potentially leading to a further rise in inflation which remains considerably above the Bank of England’s target rate.
The Eurozone economy has proved more resilient than previously expected, helped by a recovery in consumption and international tourism. However, with inflation levels remaining significantly above target, further monetary tightening is expected from the ECB which is likely going to drive economic growth expectations lower.
The UK economy, however, has continued to weaken, highlighted by the contraction of GDP in Q3 2022 which many believe will mark the beginning of a prolonged recession as rising interest rates, mortgage costs and stubbornly high inflation continue to weigh on household spending.
Whilst headline inflation levels in the UK are expected to remain uncomfortably high throughout the first half of 2023, the upwards pressure from energy and food prices will drop out of the YoY rate increase, resulting in a significant level of decline in inflation rates. Services inflation is set to remain elevated, as the tight labour market continues to increase workers’ bargaining power for pay rises, with current wage growth far too high for inflation to return to 2% without further rate hikes from the Bank of England.
Despite wage growth being above trend, it is not keeping up with inflation, meaning household disposable income levels are still being squeezed. This is likely to weigh heavily on consumer spending in 2023, further dampening the economic growth outlook.
2022 was a remarkably turbulent year for financial markets, with the global economy hit by multiple adverse shocks – from supply and demand imbalances and Covid-19 disruptions to Russia’s invasion of Ukraine. Turning towards 2023, global inflation is set to decline as central banks become more determined to take interest rates further into restrictive levels until they receive confirmation that inflation is returning to target.
Against this backdrop, it is our belief that 2023 is set to be a difficult year for the global economy, but a positive year for financial markets which appear to have priced in the majority of the key risks which lay ahead. As inflation levels decrease, the pending recessions facing many developed economies are likely to force the respective central banks into loosening monetary policy in order to stimulate their economies, with governments also able to implement fiscal support to households which have struggled to deal with the largest decline in real disposable income levels on record.
Whilst many of the downside risks now to look to be reflected in financial markets, we expect further volatility is likely to lay ahead as investors look to see how corporate profitability has been impacted by a year of record inflation. It is therefore our view that a diversified approach is crucial, with fixed income assets offering attractive yields in comparison to recent years, whilst equities are becoming more attractive on a value-at-risk basis, when looking at a long-term investment horizon.
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