We see five key themes driving global markets in the year ahead.
- To get inflation under control, central banks stay the course and push the economy to the brink of a recession.
Decades of low inflation conditioned investors to expect lasting economic expansions, short recession cycles, and short-lived asset price adjustment. The question now is whether the current cycle will upend these expectations. Will we revert back to inflation regimes when tight labor markets and persistent service inflation were slow to ease and rendering central banks were slow to pivot? Or are we set to simply experience a longer-than-expected (yet transitory) aberration in inflation trends?Either way, inflation’s path throughout 2023 could determine when we’ll see the “big pivot” in central bank policy that the markets are awaiting. The Fed has maintained its pace of telegraphed interest rate hikes; even in the face of rising recession fears, a clear deceleration in core inflation and tight labor markets is needed to usher in a pause or reversal. As of now, we believe that the rate of inflation peaked in November 2022, at least for the US market. Still, we await further confirmation of that opinion.
The European Central Bank also seems intent on maintaining its record-speed rate increases to tame inflation as recession looms. Should the Fed “hike and hold” at 4.75%-5% for most of 2023, the impact of higher rates will be tighter financial conditions, ultimately resulting in the catch-up of non-US markets.
Meanwhile, China and Japan are the only major economies currently easing monetary policy after several years of keeping it tight. Still, the impact is limited, especially in China where debt-to-equity ratios are disproportionately high.
- The renewed US dollar spells trouble for everybody else, but it could peak soon.
The dollar has reached multi-decade highs, and its outsized strength continues to weigh on other economies. On average, we calculate that the USD is overvalued by about 23%!The strong dollar is hitting both developed and emerging markets, feeding inflation and thus raising the cost of imported goods. It’s also contributing to the need for some central banks to impose their own tightening of financial conditions, even if their economies can’t take it. Spooked by fears of a global recession, investors have flocked to dollars as a safe haven, thereby accelerating the move. The Fed’s aggressive interest rate hikes have added USD dominated assets as the key buying opportunity. All-in-all, we think the dollar is likely to peak in 2023, perhaps around the midyear mark.
- Stay defensive but prepare to become more opportunistic.
Based on today’s EPS assumptions, we believe markets trade at fair value. However, depending on the next course of action, these estimates might still be too elevated. In the event EPS estimates do disappoint, we would expect the market to experience one more “wash-out.” A European recession is most likely inevitable, and even today’s resilient US economy is increasingly reliant on supportive action by the Fed to ward off its own weaknesses. Remember, although the US market is highly self-sufficient, it can’t maintain its pace without other economies picking up. - Emerging Markets: EM suffer from DM setbacks.
For the last 40 years or so, EM were the boiler rooms for the wellbeing of developed markets. The transition to self-sustainability, if there is one to be, is long and requires further political and economic stability.The COP27 conference in Sharm El-Sheikh has given several charismatic EM leaders a taste of what their nations may expect in the future. Suggested growth-oriented policy pivots may not be to these leaders’ benefit, but rather, may cause them pain. For example, developed market investors wish to see a move away from collective ownership, less centralized decision making, and a true democratic process. However, as present, exactly the opposite is taking place.
Meanwhile, steps by the Chinese government to implement less-disruptive zero-Covid policies, including steps that will ultimately pave the way for a reopening, appear to be good. Still, the government’s moves are not sufficient to unlock a downward-spiraling economy that is heavily exposed to lagging real estate development.
- Geopolitical forces hasten an investment shift toward energy and responsible investing.
The war in Ukraine has once again called the sustainability of the EU into question. Can the EU sustain over time? According to Bridgewater founder Ray Dalio, the Eurozone appears to be a strong power (#3 among major countries today), but in gradual decline. The key strengths of Eurozone are its importance to global trade, its strong capital markets and financial center, its reserve currency status, and the fact that private households are net creditors. Its weaknesses center around low self-sufficiency and its relatively poor allocation of labor and capital.What this analysis does not show is the fact that European companies are at the forefront of all major innovations, the present energy transition among them.
Given this, we believe Europe will manage through a winter without Russian energy resources, thereby producing a new energy autonomy and momentum for green energy and renewables. Multinationals and investors may also be warier about investing in countries under autocratic regimes, where the rules can change on a dime. Other markets such as the US and China will be affected by this, regardless of power struggles between the Democrats and the Republicans in the United States America or Xi’s consolidation of power. The shift away from Russian and Chinese resources, burdens the economies of developed markets with issues they have been avoiding up to now. The ramifications will be vast, be it political (internal and external), economically, and societal. In particular, develop market countries are suggested to defend better own political framework and not to this an opportunity for self-glorification for the people in place.
In the meantime, climate investments appear poised to rise substantially, offering long-term investors valuable opportunities across almost all industries.