The global economy was confronted with two negative events within a short period of time. First, the Covid-19 pandemic and second, the war in Ukraine. This has led, first, to unexpectedly high inflation, second, to rapid, sharp increases in key interest rates, and third, to weak real economic growth.
In hindsight, it is little wonder why most classes of securities have shown negative return performance over the past year. The following ten topics could be particularly relevant for the financial markets in this year 2023.
1. High macroeconomic uncertainty
The period of low macroeconomic volatility is likely over.
A) Inflation dynamics are not sufficiently well understood.
B) The dampening effects of restrictive monetary policies on the economy will not become apparent for several quarters.
C) To an increasing extent, structural factors are affecting economic dynamics (deglobalization, aging, climate change).
The three major scenarios for 2023,
A) “continued decline in inflation” (positive for economic growth),
B) “stagnation” (predicted by most institutions), and
C) “global recession” (when inflation falls only a little) could alternate as the driving factor for financial markets in the coming months.
At the beginning of 2023, optimism prevailed among investors, unlike commentators and analysts. Stock and bond prices have risen. In Europe, the rapid decline in energy prices and fiscal support measures have led to an improvement in economic indicators. The indications of “merely” stagnation are growing stronger. In the summer, there were fears of a severe recession. In China, the unexpectedly rapid departure from the zero-tolerance policy toward new infections and the selective support measures for the real estate sector argue for an economic recovery in H1. In the USA, any falling inflation indicator seems to be interpreted as an indication of a less than feared restrictive monetary policy. Most recently, lower-than-expected growth in average hourly wages for December boosted market prices. However, possible disappointments in the further course of the year are likely.
2. High geopolitical uncertainty
The war in Ukraine is called a war of attrition. The side with the greater economic resources has an advantage, perhaps a decisive one. Thus, the nature and extent of the West’s support for Ukraine remains a major factor influencing future developments. In any case, the war in Ukraine has permanently damaged the West’s relations with Russia. The effects have been stagflationary. This is most visible in the rapid shift to alternative energy sources.
Increased tensions between the US and China, manifested in export and investment restrictions by the US, among other things, are also having a stagflationary effect. The notion of “nearshoring” as a consequence of the pandemic is joined by “friendshoring.” The widely discussed possibility of an escalation around the Taiwan issue would probably have an even more negative impact than the war in Ukraine.
3. Restrictive monetary policies
The past year has been characterized by rapid, broad-based key rate hikes. Major central banks are currently signaling their intention to raise policy rates to restrictive levels and to maintain these levels for some time. However, the higher the key interest rates are raised, the more likely a pause in the rate hike cycle becomes. Central banks are aware of the time-lagged and uncertain effect of monetary policy on economic growth and, even more uncertainly, inflation. Whether this pause is actually just a pause (further rate hikes), an end (with interest rates remaining restrictive) or a reversal (rate cuts) will be decisive for market price developments. In any case, relying on interest rate cuts contradicts the central banks’ forward guidance (guidance of market expectations).
4. More unstable financial market
Last year, key interest rate increases led to a higher discount factor for future cash flows (profits, coupon payments). Significant price declines were the result. Unexpected, further key rate hikes would prolong this process. The risk of liquidity crises similar to the one in the United Kingdom last September could increase once again.
5. High debt
During the phase of zero and negative interest rate policies coupled with extensive bond purchase programs by central banks, high (government) debt did not pose an immediate problem. However, the key interest rate hikes and the central bank balance sheet reduction programs that have started increase the risk of countries (as well as companies and individuals) with high debt. This increases (in theory) the required spreads for risky debtors compared to an environment of excessive liquidity.
6. Higher Risk Premiums
The new regime of fallen stability at the macroeconomic, geopolitical and financial market levels, together with lower central bank liquidity, requires higher risk premia in equilibrium, in theory. In other words, the higher expected risk increases the required risk premiums. The immediate potential for price increases is therefore lower. This does not sound so bad, were it not for the price adjustment process towards this theoretical equilibrium. If one takes a look at the market development since the beginning of the year (price increases in equities and bonds, fallen priced-in volatilities), market prices may soon have priced in too much of an optimistic scenario (continued decline in inflation), but neither a realistic one (stagnation), nor a pessimistic one (global recession).
7. Price increases in bonds – not a one-way street
Falling inflation is generally positive for bonds. Currently, the decline in inflation is mainly driven by falling goods and energy prices. However, the labor market remains very tight (low unemployment rates) and inflation persistence may have risen permanently. Central banks are signaling that, in order to ease monetary policy, they need to be highly confident that inflation will fall toward the central bank target and stay there.
To bet on a sustained decline in inflation would be bold. After all, service price inflation could remain uncomfortably high. Then there are the very difficult-to-assess effects of central banks reducing their bond portfolios (quantitative tightening). At least the bond environment this year is not as predominantly negative as it was last year. However, the environment is likely to be characterized more by high volatility than by an upward trend in prices.
8. Equities – recession risk not adequately priced
As a rule of thumb, stock prices (especially) fall during a recession. Does this mean that the fall in share prices last year already reflects a recession? Probably not. After all, the main reason for the price declines was the rise in interest rates. The two scenarios “disinflation” (very positive), and “stagnation” (cautiously positive) represent a favorable equity environment. However, the risk scenario of a global recession does not seem to be adequately priced. Two negative stock market years in a row are very rare. That would require two shocks, such as interest rate hikes and a recession.
9. US dollar – not so clearly negative
Since the priced-in real government bond yields in the USA have stopped rising (index currently at 1.8%) or expectations for future key interest rates have not risen further, the US dollar has tended to weaken against the other currencies. However, the traditional indicators still point to an overvaluation. Further weakening is suggested by many commentators, but it is not so clear. This could occur mainly if the optimistic scenario (disinflation) becomes more likely. The other two scenarios, however, tend to argue for a sideways movement (stagnation), and for renewed firming (recession), respectively. Traditionally, the US dollar is a countercyclical currency, and the US central bank has shown a strong willingness to get inflation under control.
10. Commodities – positive
Low global economic growth suggests subdued demand for commodities. However, the rapid shift to non-Russian energy sources as well as sustainable energy sources could structurally support commodities. In addition, there are the geopolitical risks “China” and “Iran”. At least as a hedge against further geopolitical escalation, commodities remain interesting.
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Prognoses are no reliable indicator for future performance.