2023 Market Outlook
Introduction
After a bruising and turbulent 2022, world economic growth is expected to slow in 2023. Recession is widely assumed in many developed markets as we move through the contraction phase of the economic cycle.
It could be relatively short and shallow, with corporate and household balance sheets reasonably robust and labour markets tight. However, aggressive and synchronised monetary tightening by central banks through 2022 has raised the probability of an unexpected financial crisis. And with property markets weakening due to declining affordability as mortgage rates rise, negative wealth effects and elevated geopolitical risk leave investors with much to consider.
Following sell-offs across markets in 2022, valuations are now considerably more attractive. As firm advocates of medium to long-term risk focused investing, the valuation reset experienced by many markets last year presents an interesting outlook. However, with volatility likely to remain elevated, diversification is expected to be key, alongside discipline and commitment.
Whilst the short-term outlook may appear challenging, this contraction phase (however long it lasts), sets us up nicely for the recovery and expansion phases that typically follow. Our 2023 Market Outlook outlines our 4 key market risks and opportunities for the year ahead.
Risks
1. Inflation and interest rates – at or near a peak
Inflation, already in the ascendancy in late 2021, accelerated last year and became far more widespread than anticipated
Supply side bottle necks eased as the year progressed, but labour market tightness combined with geopolitically driven higher energy prices led to aggressive and coordinated central bank monetary tightening. As a result, headline and core inflation began to moderate. Some elements within the inflation basket are proving sticky though, most notably wages and rents.
High frequency rental indices reflecting recent rental agreements point to a notable deceleration. This suggests a likely moderation through 2023, helping move both headline and core CPI down. With rents making up over 32% of CPI, this tends to be a relatively slow moving but key component of the inflation basket.
With the number of job openings to unemployed remaining elevated at around 1.7, upward pressure on wages is still a material concern. However, given short and long-term inflation expectations have moved towards the Fed’s 2% target, the risk of wage pressure leading to a sustained inflationary spike is likely to moderate in 2023.
With unemployment at just 3.7%, the Fed seem determined to continue increasing interest rates, which will likely slow the economy, increase unemployment and reduce demand. The impact is already being felt as new hiring shrinks, job vacancies contract and increased redundancies are announced. As a result, the Fed’s aspiration to achieve a ‘soft landing’ is looking vulnerable, especially as we have just seen the fastest rate hiking cycle in recent history. Given monetary policy works with a long and variable lag, the ramifications of this rapid tightening aren’t likely to truly surface until later in 2023, possibly even into 2024.
2. Yield curve inversion, recession and refocus on growth
The yield curve has been a reliable indicator of future economic activity, especially forecasting a recession whenever it inverts
Following the aggressive increase in interest rates through 2022, we have seen the largest yield curve inversion in the US since the 1980s, with the UK Gilt curve similarly becoming inverted in Q4 2022 after the Bank of England raised rates for the 9th consecutive meeting in December.
The difference this time is that it’s the most widely anticipated recession on record by economists and investors, albeit expected to be shallow in intensity and short in duration. With central banks resolute in their determination to re-establish their inflation fighting credentials, the risk is that interest rates being higher for longer leads to a deeper and more prolonged recession than currently discounted by the markets.
For this reason, it is expected that growth will increase in importance for investors as the year unfolds and inflation stops being the dominant headline. Central banks are not expected to ride to the rescue with monetary largesse as they’ve tended to since the global financial crisis of 2008/9. Instead, sustainable and prudent economic growth plans will likely be adopted by governments, which investors can more accurately evaluate and hopefully get behind.
3. Wealth effects, house prices and consumption
Global equity markets contracted around $15 trillion in 2022, with global bond markets losing close to $30 trillion
This, along with the cost-of-living crisis, has seen consumers increasingly draw upon their savings to get by. This isn’t sustainable and suggests slower consumption activity in 2023.
Property, a long-time recurring source of wealth accumulation and stability, is also facing a challenging outlook. With mortgage rates ballooning, the inevitable deterioration in affordability has led to a slump in housing transactions and ten consecutive monthly price declines. Housing makes up close to 20% of GDP in the US, so the impact of the bear market in property shouldn’t be underestimated. High single/low double digit US property price declines are forecast by many for 2023, pointing towards slowing consumption as the negative wealth effect kicks in. Consumption makes up just under 70% of US GDP, so this suggests a softer economic outlook.
4. Financial accidents and geopolitics
History is littered with examples of crises and incidents whenever meaningful monetary tightening occurs
It’s unlikely to be any different this time. We’ve already seen the Bank of England shoring up the Gilt market following the liability-driven investment crisis triggered by the mini budget as well as a shakeout in cryptocurrencies. Further incidents are likely as the impact of interest rate increases work their way through the system. These can be unpredictable, so being diversified is the best way to stay protected.
Russia’s appalling invasion of Ukraine has reminded investors that geopolitics is a risk they need to bear in mind. Hostilities prevail around the world, and in times of increased economic difficulty they can often bubble up.
Opportunities
The upside following a sell-off of the scale and magnitude seen in 2022 is valuations now appear much more interesting. Further challenges will undoubtedly surface in 2023, but for many asset classes long-term potential returns are back in relatively attractive territory.
1. Fixed interest – bonds are back with risk off and yield on
The fixed interest sell-off has lifted yields to levels looking much more appealing
Short dated bonds remain sought after given their reduced sensitivity to rising interest rates plus attractive coupons. With inflation showing signs of peaking, longer dated bonds are becoming more enticing too. Positive real yields are now available - and with scope for capital appreciation should monetary policy relax from here - longer dated bonds appear well positioned to benefit investors.
Global liquidity is expected to tighten as economic activity slows and central banks reduce their balance sheets (known as quantitative tightening), so companies that can deliver strong recurring income are likely to find favour with investors. Security of yield rather than absolute level of yield is expected to be the key to success for fixed interest investing in 2023 – returning, arguably, to what fixed interest was always supposed to do: provide stability of income.
2. Equities – changing of the guard
For multi-asset investors, the weakness seen in equities through 2022 has helped bring valuations back beneath their long-term averages for all markets other than the US.
With an economic recession widely assumed by investors, the question is: how resilient will markets be to a profit recession? Experts believe that, with investors defensively positioned and fund managers holding cash positions near levels last seen in the dotcom crisis, further consensus earnings downgrades are already widely anticipated. Time will tell if they are right.
Incidentally, if enthusiasm from fund managers anecdotally is anything to go by, investment opportunities seem to have become more plentiful and more attractive.
3. Small caps – down but not out
With rising input costs and slower top line sales squeezing margins as economic activity contracts, small caps have had a torrid time
Their domestically biased orientation has also weighed on the asset class. However, if inflation does materially and sustainably decline, small caps are expected to be a prime beneficiary, as investors will increasingly look through the contraction phase of the cycle in anticipation of an economic recovery.
4. Dollar and Emerging Markets
The risk off environment of 2022 saw the US dollar continually appreciating
This acted as a material headwind for Emerging Markets, despite many of these countries actually demonstrating greater proactivity and fortitude in controlling inflation. With interest rate differentials expected to narrow and, crucially, Chinese growth anticipated to pick up as they move away from a zero Covid policy, the US dollar strength is forecast to reduce. This will act as a material tailwind to a deeply unloved, under-owned asset class where expectations are very low.
The relaxation of China’s Covid restrictions, combined with supportive property sector policies and pursuit of technological progression and independence, all evidence the newly appointed Politburo’s ambition for common prosperity and ‘inclusive growth’. It’s not expected to be a rapid bounce back like the West after their Covid lockdowns, but instead measured, targeted and deliberate to avoid the risk of unwanted excess building like it has before. If successful, this will boost not only Emerging Market growth but also global economic activity, and the whole world would benefit.
On balance
Investing was relatively straightforward for investors in the decade before 2022. More often than not, taking on risk brought success as central banks and governments looked to provide much needed support. That support has now been removed, creating a much more challenging backdrop.
With many uncertainties remaining for investors through 2023, and most probably into 2024, humility, patience and perseverance are expected to be key to any successful investment strategy. Expect the unexpected, maintain diversification, and align attitude to risk and capacity for loss carefully with portfolio Risk Grade.
Disclaimer: Any news and/or views expressed within this document are intended as general information only and should not be viewed as a form of personal recommendation. Journey Invest Limited accepts no duty of care or liability for loss occasioned to any person acting or refraining from acting as a result of any material contained within this document. Please note past performance is not an indicator of future performance, investment returns can go down as well as up.