The economy and markets
Key points to know
Inflation should finally decline.
Global inflation remains very high heading into 2023, but we see signs it has peaked. As consumer spending growth normalizes and the goods/services balance is restored, corporate profit margins will likely compress. At the same time, global real estate and labor markets are showing signs of returning to balance, reducing upward pressure on rent and wages, both key drivers of inflation. Energy costs remain a wild card with geopolitical risk influencing oil and gas prices, but even a plateau at current levels would provide a meaningful drag on global headline inflation over the next few quarters. Countries where central banks have already layered in substantial policy tightening appear to be ahead of the game in bringing down inflation (Figure 2).
But economic growth will slow, too.
Investors will celebrate the easing of inflation and the corresponding lessening of pressure on central banks to tighten policy. But in the wake of declining inflation, we’ll find a global economy still nursing a hangover from the post-pandemic reopening binge, hampered further by higher borrowing costs and diminished savings. This may lead businesses to slow their pace of hiring — or reverse course to reduce headcounts — which will, in turn, weaken consumer spending even if income growth once again starts to outpace inflation. Countries like China and Japan remain sensitive to export demand but have also seen their domestic economies struggle. Meanwhile, Europe’s fate remains closely tied to global commodity prices, energy preparedness and, yes, the weather.
Inflation risks may be fading. But recession risks are growing.
We expect varying resistance to recession across countries.
2022 pitted the irresistible force of higher rates against the immovable objects of consumer spending and hiring demand. For countries to stay out of recession in 2023 — or keep those recessions mild when they occur — it will take a combination of carefully calibrated monetary policy and increased use of consumer balance sheets (i.e., reduced savings and increased credit). Job security will become the key variable to watch for consumer strength. Consumers save less and spend more when they feel confident in their employment prospects. While unemployment rates remain low around the world, the “immovable objects” will likely start to budge sooner in Europe and emerging markets than they will in the U.S.
Policy risks aren’t going anywhere.
Ask most investors, and they’ll tell you that inflation was the single largest obstacle to generating positive returns in 2022. But that’s not quite right: It was actually central banks’ collective response to that inflation that sank diversified portfolios. Higher discount rates took down equity valuations — though not profits just yet — and led to substantial losses on most categories of fixed income. The risk that rates go even higher as central banks struggle to fully break inflation may keep markets on edge. And even if policymakers sound the all clear on further rate hikes, the environment that follows is likely to feature either higher rates for a prolonged period (our base case), or a dramatic rally in government bond markets driven by a severe macroeconomic downturn (our primary downside risk case). Neither of these scenarios promises a smooth melt up for diversified portfolio balances in 2023.
All market and economic data from Bloomberg, FactSet and Morningstar.
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A word on risk
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