The 'circular economy'

Moving into 2023, inflation is past its peak, and investors are shifting their attention towards the economic growth outlook, and when the world’s major central banks will pivot on policy. However, the economic growth outlook still remains contingent on inflation, albeit the second derivative is now more important. Markets are betting on a relatively rapid slowdown in price growth, and there is a reasonable chance that they will be proven right (despite a near consistent track record of being wrong in the past); led first by lower commodity prices and outright deflation in some goods prices (supported by a normalisation in global supply chains), and subsequently reinforced by weaker consumer spending, feeding through to services prices.

‘Don’t fight the Fed’

For this dynamic to play out, wage growth needs to moderate from current levels. In a best case scenario, this can happen without a significant rise in unemployment. But central banks are not taking any chances, instead focusing on stamping out any signs of persistence in inflation in a bid to restore credibility in their inflation-targeting credentials. This may lead to a stubbornness in policy that intensifies the economic downturn in the second half of this year; the ‘long and variable lags’ of monetary policy mean that central banks are forever chasing their tails. The chief protagonist in this regard is the US Federal Reserve (Fed), which is currently engaged in a battle of wills with Wall Street over the future path of interest rates.

Stagnation or recession

Consensus forecasters are broadly coalescing behind a global stagnation or a mild l recession for 2023. The slowdown is most acute in Europe, underpinned by a cost of living squeeze and crisis in energy supply. The US economy is showing more resilience, but here too a recession is more likely than not.

Indeed, proponents of using the yield curve as a predictor of economic outcomes would say a recession is preordained, as the full impact of a restrictive monetary policy comes to bear on the real economy, most notably the housing market. Across the Asia Pacific region, inflation is generally peaking at lower levels. But growth in many economies is highly geared to the global economy, and to China, where authorities are rapidly disbanding zero- Covid rules.

It's what you don't know that hurts you

The good news is that there is no obvious sign of systemic stress that could turn recession into depression; banks are well capitalised, and households and corporates are generally well positioned financially. But in the words of Warren Buffet, “only when the tide goes out, do you see who has been swimming naked,” and there remain acute vulnerabilities in the global economy; few in the UK were paying close attention to ‘Liability Driven Investments’ before September.

Principal amongst them is the potential for financial distress in highly leveraged sectors that could permeate through global markets. The stock of global debt was equivalent to nearly 250% of GDP in 2021, nearly 20% above pre-pandemic levels.Sectors reliant on leverage, such as housing, are vulnerable to higher rates. Regulatory rules enacted post global financial crisis have pushed risk away from traditional lenders to more opaque shadow lenders where the stress points are less obvious. And even when rates peak, central banks will continue to withdraw liquidity via quantitative tightening programs (financial crises’ are usually caused by a lack of liquidity).

Some room for optimism

While risks remains skewed to the downside, there is some upside potential also. Falling global inflation could provide some breathing space for central banks and ease the cost of living crisis inflicting most of the world’s households. China’s reopening could inadvertently support this dynamic; in the first half of the year, the disbandment of zero-Covid rules could mean lower commodity prices as Chinese growth stalls amid high infection rates and pandemic fear, supporting a disinflationary trend in the rest of the world. In the second half of the year, when global growth is bottoming out, a resurgent and policy stimulated Chinese economy could support a rebound in global demand. Meanwhile, Europe has effectively managed the energy crisis for this winter, supported by unseasonably warm weather and a strong behavioural response to higher prices. And economic data in general continues to hold up better than sentiment-based indicators, suggesting a level of resilience that forecasters may not yet appreciate.

A baseline with elevated volatility

For financial markets, 2023 should be considerably easier to navigate than 2022, particularly given there is more certainty on inflation and interest rates. However, even when the hiking cycle comes to an end, financial conditions will remain tight, and real yields are likely rise further in line with slowing inflation. While equity markets are supposed to be forward looking, there is also a question as to whether they are appropriately discounting an earnings recession, particularly in the US. Further out, the general consensus that the future will be more volatile, underpinned by geopolitics and deglobalisation, climate change, and demographic change.