And breathe – 2022 is over and we’re not unhappy to turn the page. According to the Financial Times, who knows a thing or two about markets’ history, it was the worst year for a portfolio combining stocks with bonds since… 1871.
Today we’ll have a look at what happened, but also, as 2023 starts on a strong note, at what has changed, or not, and share what we’ll watch in the year ahead.
Inflation, unleashed.
2022 was about one factor: the return of inflation in the West, which triggered radical responses from central banks: the end of decades of monetary largesse. Let’s develop.
Just 15 years ago, the cumulated size of the balance sheets of G4 central banks was around $5 trillion. It jumped to $15 trillion in the decade which followed the great financial crisis, with ultra-low interest rates. Then, when Covid hit, another $10 trillion was printed from thin air, at zero interest rate, in only 2 years. Inflation rises when too many dollars chase too few goods.
Through government support, the Covid trillions had reached the pockets of consumers, and they were just waiting for a catalyst to be unleashed. Economies reopened before supply was repaired, between China’s Covid struggle and the commodity disruptions from the war in Ukraine. After goods, demand for services went ballistic, creating a boom in employment. Higher salaries, more consumption, more growth, more employment, higher salaries, higher costs, higher prices, and so on.
Inflation came back, reaching levels unseen since the 80s. Long gone are the hopes for a transitory phenomenon: the risk is a wage-price spiral, and central banks have no other option than to aggressively pressure demand and employment to combat inflation. That is, making money scarce and expensive by brutally raising interest rates.
The problem for investors? It is bad for everything. Bond prices are directly hit by rising rates, but so are equity valuation multiples, as well as their earnings perspectives, as monetary tightening explicitly pressures activity. Correlation snowballed to push all asset classes in the red in 2022, with cash being the only exception.
What about 2023?
Let’s start with the good news. Inflation is moderating. CPI headline numbers, which are the broadest measure of the price increases affecting consumers, dropped from a summer peak of more than 9 percent in the West to less than 7 percent in December. It’s getting better.
Second good news: while this is still far from central banks’ formal target, the trend is positive enough for them to slow the pace at which they hit the economic brakes. The Fed hiked their policy rate by an unprecedented 425 basis points in 9 months in 2022. According to the consensus and to our own economists, this should be topped by a more digestible 50 basis points this year. A pause should follow, and then, once inflation is under control, rate cuts should happen.
It all depends on the inflation trajectory, first and foremost, but also on the growth trajectory. The positive scenario is gaining traction and explains the “rally of everything” in the first 10 market days of 2023: inflation could be under reasonable control before too much damage is inflicted to the economy.
Indeed, if the global economy is undoubtedly sharply slowing down, it looks manageable. The US shows the sharpest deceleration, with the most hawkish monetary tightening, but with an unemployment rate at 3.5 percent only, it looks strong enough to avoid a recession. Europe is more vulnerable, but the latest activity indicators point to the risk of a modest contraction rather than a severe one. Finally, but importantly, China’s 180-degree turn on Covid policy is a potentially welcome boost to global activity, even if its impact on inflation is another unknown.
A dual risk to watch
2023 is all about the relative trajectories of inflation, and growth. With regards to activity, the bad news is that the moderating impact of higher interest rates takes time to affect the entire economy. The current situation feels good, but for how long? A recession would be the result of too much pressure from central banks, thus the first thing to watch remains inflation, and its main driver, the US job market.
For the former, central banks’ formal 2 percent target on core inflation looks difficult to reach, but 3 percent would be acceptable. For the latter, the most important is the evolution of wages: if it doesn’t materially calm down, the response will be more tightening, because a wage-price spiral is the worst nightmare of monetary authorities.
We should also watch growth carefully. The most awaited “magic moment” of the Fed pivot may happen for bad reasons: a severe recession before inflation materially abates. This would lead to another 2022, potentially even worse as we would see bankruptcies and pressure on the financial system. This would ultimately lead to support from authorities, but it would be painful.
This is not our central scenario, but at some point the focus will switch from inflation risk to recession risk. Bottom-line, the great start of 2023 is not necessarily the beginning of a tremendous investment year. We are reasonably constructive, but unpredictability is back and volatility will not vanish.
Originally written on January 12th, 2023
Follow us on
