Feature Stories | Dec 07 2022
2023 Outlook: Global
Is a global recession afoot? If so, how should investors position themselves for 2023?
-What is a recession really?
-Slow going for global economy
-Structural elements of inflation
-The new (old) normal
-Ongoing bear market
By Greg Peel
The problem with recessions is that you don’t know whether you’re in one until you have been. Today in Australia we’ll learn the result for the September quarter GDP – two weeks before the end of the December quarter.
The Australian economy grew 0.9% in the June quarter so there is no risk of recession, nor is a negative growth quarter expected in September. But had June seen GDP contraction and September proved to show further contraction, then the media would have a field day:
“It’s official: Australia In Recession!”
Or at least it was. If you accept the technical definition of two consecutive negative quarters. But nearly three months after the end of the second of those quarters, are we still in a recession? We could well be rocketing back out.
That’s what happened in 2020. The June lockdown quarter brought -7.0% GDP contraction, after a slight contraction of -0.2% in the March quarter which just caught the beginning of the lockdown. For the first time in 26 years, we were “in recession”. Then in the September quarter the economy grew 3.5%.
Delta lockdowns brought -1.8% contraction in the September quarter 2021, but the December quarter saw a swift 3.9% rebound. Inflation and RBA rate hikes have slowed the economy to a crawl in 2022, but not into contraction. Yet.
Of course, many scoff at the two-quarter technical definition anyway. The US economy contracted by -1.4% in the March quarter this year and -0.6% in June, and no one said “recession”. September saw a rebound of 2.9%.
In the US a recession is “officially” called by the National Bureau of Economic Research.
Officially, the NBER defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” The bureau’s economists, in fact, profess not even to use GDP, the broadest measure of activity, as a primary barometer.
And they’re not exactly a bunch of Usain Bolts. The NBER declared the 2020 recession in July 2021.
Thanks Scoop.
So forget definitions. Probably the simplest definition of a recession is that if you feel like you’re in one, you are. And if people keep telling you a recession is coming, and you respond accordingly, it will.
And the two-quarter definition implies two sole GDP measures to decide the country is in recession. In the 2010s Australia did not see a recession, but we did see a “two-speed economy” – miners versus everybody else. For everybody else it “felt” like a recession, which basically means for everybody else, it was.
Another thing about recessions is they are typically not so predictable. Covid came right out of the blue, the GFC was slower moving but followed an unforeseen (by most) US property crash, the long seventies recession was led by unforeseen Arab oil shocks. Maybe the nineties recession was more predictable, given Volker had been trying his best to invoke one, hence it was “a recession we had to have”, but if the world, the US or Australia hits a recession in 2023, I think it would be the most pre-warned recession in modern history.
Which could mean one of two things.
There is a market adage that if everyone has the same view at the same time, the opposite will happen. That’s why, for example, market analysts place so much faith in “contrarian” indicators. On that basis maybe recession will be avoided.
But I just said the best way to cause a recession is to assume one is coming. Batten down the hatches dear, things might get tough. Stop spending now.
So we’ll probably see one next year. At this stage it’s the US, more probable, and for Australia, possible.
The world economy is set to slow, with Europe bound for an energy crisis-led recession, China to remain slow if it continues with zero-covid (but late indications suggest it won’t), and the US somewhat of a swing factor.
Recession(s) will be experienced because central banks will make them happen, just as Volker did, as the only means of combating inflation. If we have it, it will be another recession we had to have.
So with that in mind…
Slow Going
Morgan Stanley forecasts global growth to have slowed to around 3% in 2022, down from 6.2% in 2021, and fall to 2.2% in 2023. Growth will be uneven, with developed markets to be in or near recession, while emerging market economies should recover modestly.
Globally, inflation should peak in this December quarter, Morgan Stanley believes, before disinflation takes hold in 2023. Headline inflation will ease on general stability in oil prices and an improved global supply of food. Core inflation will see the effects of slowing demand and an easing of supply chain constraints, leading to lower consumer goods inflation, and slower growth, weaker demand and more normalised labour markets impacting on services inflation.
Developed market central banks will continue to tighten policy into restrictive territory and then stay there, plateauing throughout 2023, with the Fed holding on the longest. China and Japan are not worried nor overly impacted by inflation and will retain an accommodative stance.
Morgan Stanley notes however that there are risks to such a view. Another wave of commodity price shocks would lead to another temporary upside inflation surprise. A further increase of geopolitical tensions may again disrupt supply chains. Central banks may have to hike further.
The broker places some faith in China providing demand support after reopening from zero-covid restrictions in the northern spring of 2023. “Recent comments from policymakers in China to minimise economic disruptions and the fine-tuning of aspects of covid policy suggest to us the direction of travel is toward reopening”.
Morgan Stanley published its 2023 outlook reports around mid-November. At the time, the world was indeed excited over news Beijing had formed a committee to assess reopening, and the Wall Street Journal had us convinced this was indeed the plan. Beijing’s response was swift and definitive.
Rubbish.
Beijing doubled down on zero-covid, citing “science-based evidence”, at least until there were riots in the streets. Xi was left with two choices: send in the tanks or shift away from zero-covid, providing a simple, science-based excuse as to why.
Suddenly the government believes covid is not actually as bad as first thought. Hence it now looks like a much-feared ongoing slowdown in China’s economy in 2023 may not come to pass after all.
Morgan Stanley may thus be right about China's reopening, but warns:
“A delayed reopening in China could have non-linear impact on China’s growth trajectory, with adverse spill-over implications for the rest of the region.”
Taming the Beast
Oxford Economics agrees China (and Russia) remain sources of uncertainty when to comes to inflation trajectory predictions. Otherwise there is now greater scope for supply-side developments to push down core inflation, particularly in the goods sector where easing bottlenecks, inventory unwind and lower commodity prices should all weaken pipeline price pressures.
Oxford expects food and energy inflation to fall sharply from here, but the rate of fall in 2023 is uncertain, and unlikely to be as swift as was the case in the GFC.
Over 2008-09, above-target inflation quickly morphed into deflation, the economists note. The best cure for high prices is high prices. But they would be cautious in concluding inflation will fall far below target in 2023-24.
Oxford notes supply-side factors have been important in leading inflation, hence there should be a substantial fall in eurozone core inflation. But a more gradual easing is likely in the US given demand-side forces have played a larger role.
Fidelity International believes inflation is likely to remain elevated in 2023, increasing the risk that over-tightening by central banks will trigger a sharp recession.
For most of the second half of 2022 to date, two words have dominated final market anticipation: “pivot” and “pause”.
“Pause” is sufficiently straightforward, implying a central bank will lift its cash rate to a certain level and then stop lifting it. “Pivot” is a little more vague. It means to change policy direction, which would be to start cutting rates again. But then a pause would also be a change in direction, and thus a pivot, at least in some minds.
Assuming pivot means cutting rates, the Fed has made it abundantly clear this is simply not going to happen in the foreseeable future. FOMC members have most recently suggested a pause will soon be appropriate, but not until the cash rate is well into restrictive territory, which at last count is 5% or higher.
The current rate is 3.75-4.00%, with another 0.50% expected at the December meeting.
Fed chair Jerome Powell has all but confirmed the 50 point hike this month, as the lag effect on the economy suggests a moderation of the pace of hikes is now appropriate, but also warned rates would remain higher for longer.
Once at an appropriate level, the cash rate will stay there until inflation is back in the 2-3% zone (core PCE).
Of course, the Fed is unlikely to endorse any possibility of a pivot back to cutting rates, as this would imply they got it wrong in not hiking soon enough and wrong again in hiking too far. The driver of the market’s pivot expectations is exactly that – the Fed will go too far and send the US economy into a “hard landing” recession, forcing a swift switch to policy easing.
In Fidelity International’s view, a hard landing for the US economy remains the most likely outcome in 2023.
“Until markets absorb this fully, we could see sharp rallies on the back of expected action by the Fed, only for them to reverse when it doesn’t materialise in the way they expect. Rates should eventually plateau, but if inflation remains sticky above 2 per cent, they are unlikely to reduce quickly.”
A key swing factor, Fidelity notes, is the US dollar. The strong dollar in 2022 has proven a “wrecking ball” for other economies, both developed and emerging.
Developed economies have imported inflation via high-dollar costs of goods. Emerging economies have suffered crippling US dollar debt repayments. In Australia, imported inflation has been balanced by exported inflation – extremely strong AUD commodity prices. US dollar strength has reflected the Fed’s lead in raising interest rates ahead of and further (among developed economies) than everyone else.
If the dollar continues higher, recession risk is greater outside the US. If it is weaker, the world will be relieved, and overall liquidity should increase.
The New (Old) Normal
It is oft pointed out that given it’s been 14 years since the GFC, a whole generation of youngsters joining the financial markets in that time have up until this year never known anything other than zero cash rates, or close enough to zero. For them, life is now very strange, and far from normal.
For anyone who’s been around the traps a bit longer, while today’s cash rates seem unusually high, they’re only at levels familiar in the past, and indeed still lower than most grew up with.
Thus today’s policy settings are a New Normal that’s really an Old Normal.
There have been other strange occurrences. Higher interest rates now mean fixed income investment is actually becoming a viable alternative to equity (or property) investment, after over a decade of TINA for equity markets. And while Dad always said the best portfolio is one that balances equity and fixed income allocations, as they move in opposite directions, in 2022 both equity and bond prices have moved down in tandem.
This is not unprecedented, but irrespective of one’s age, it’s unusual.
Following such a dislocation, Allianz Global Investors suggests investors might expect a recovery ahead. But much will depend on the path of inflation and interest rates and the severity of any global recession. Caution is warranted, says Allianz, but there could likely be opportunities for investors during the year as the global economy adjusts to more “normal” conditions.
Neither the pandemic nor the war were expected at first to last as long as they have, hence one then the other led central bankers, including the Fed and RBA, to assume inflation would be “transitory”. But while these external factors have clearly had an impact, Allianz has long argued structural factors are also to blame.
It took a long time for excessive monetary stimulus rolled out after the GFC to be wound back, sowing the seeds of inflation. Then followed excessive monetary and fiscal stimulus to counter the pandemic. Meanwhile, several structural factors are now contributing to a longer term inflation environment: deglobalisation, which is putting supply security above the search for the cheapest manufacturing destination; stronger wage dynamics (tied in to deglobalisation); and the fight against climate change, which is driving money to be invested in projects it would otherwise not be on a return on investment basis.
Hence while the scale and speed of central bank tightening in 2022 has surprised markets, Allianz still believes the market is underestimating where rates will end up, and for how long they’ll stay there.
The Fed will likely need to rebalance well above the “neutral” rate and into restrictive territory, Allianz warns, which would imply 5% or above. Since the Allianz outlook was published, US futures markets have moved to pricing in 5%. Last week Fed Chair Jerome Powell warned that while the pace of rate hikes will likely now slow, the time spent at the ultimate peak rate will be longer.
While inflation is set to fall in 2023, Allianz does not believe it will fall by enough to prevent further central bank tightening. There may have to be a pause if economies fall into a recession, but that then introduces the risk of more government fiscal stimulus, which will have to be met by further monetary tightening in order to prevent another inflation breakout.
We are already seeing the signs in Australia. The government has managed to pass a new industrial relations policy that will lead to higher real wages after a decade of intended stagnation – most urgent now following the surge in the cost of living. But the easiest way to fire up inflation is to raise wages.
The RBA has slowed its pace of rate hikes, and there are even suggestions it may now pause, but not if a wage-price spiral becomes a threat.
Will economies fall into recession?
It’s a “yes” from Allianz in the case of the US. A strong labour market has shielded the economy so far, but the higher cost of finance and declining real incomes due to cost of living increases will drag. Corporate earnings growth will slow, leading to a suppression of corporate investment. All add up to a downturn.
It’s a “yes” for Europe as well, probably from this December quarter, given the energy crisis.
For China it’s matter of providing ongoing monetary and fiscal stimulus to counter property market headwinds and zero-covid. But as noted, zero-covid has since potentially been given an end-date.
A global recession, or at least recessions in parts of the globe, is a major headwind for the price of risk assets, Allianz notes. But if the past is any guide, markets start looking out the other side to beyond recession about half way through the recession, and that’s when longer term investment opportunities arise.
So, how long is a recession? Yes, well, that’s the slight flaw in the plan. No one blows a whistle at half-time.
More likely there will be a first-half overshoot of weakness, which soon lures the first bold buyers, who then lure others. Typically the nadir occurs when investors simply could not be any more pessimistic.
In the “new old normal” we are now moving into, Allianz is seeing potential ideas in fixed income assets, starting with government bonds, and moving eventually into investment-grade credit.
While markets will remain volatile heading into 2023, it could be the time to position portfolios for the long term, focused on high-conviction thematics such as national security, climate resilience and innovation, and sustainability.
Darkest Before the Dawn
In a rare occurrence, stock and bond markets have collapsed simultaneously this year, leaving investors with few safe havens. Historically, after stock market sell-offs of this year’s magnitude, equity returns have been quite robust looking ahead a year or more.”
Clearly T. Rowe Price is on the same page as Allianz Global Investors.
Central banks will remain resolute in containing inflation in 2023, T. Rowe believes, but they tread a difficult line with the global economy slowing and possibly entering a recession. The Fed is between a rock and hard place. Its key challenge is how to navigate a soft landing without appearing to be dovish on inflation.
Equities markets are likely to remain volatile until the virulence of inflation becomes clear. The severity of any recession will be a key driver of market performance next year.
T. Rowe Price also agrees with Allianz on the structural inflation front. Longer term, interest rates and inflation are likely to remain higher than levels we have seen over the past decade, the analysts suggest, as deglobalisation, “on-shoring”, and increasing geopolitical risks create structural changes in the global economy.
“On-shoring” – bringing manufacturing back to the country of residence – is a catch-cry that largely began with Trump, became more prevalent following covid supply chain crunches, and even more so since the war has exposed sovereign vulnerabilities. Supply chain security is one thing – national security is another.
More recently another new, rather clumsy expression has cropped up – “friend-shoring”. If it’s too expensive/time consuming to on-shore, the next best thing is to shift supply reliance on to trusted allies.
The next decade of equity market leadership, following the last ten years of dominance by growth companies, is likely to be broader, T. Rowe Price suggests, and may favour companies with “shorter-duration cash flows”, including value stocks.
Since the GFC, equity markets, particularly the dominant US equity market, have been dominated by “growth” companies. Arguably this began earlier out of the embers of the 2000 Tech Wreck, which only the strongest survived – such as Microsoft and Amazon.
An exponential trajectory in innovation has driven the rise and rise of growth stocks this century, bringing us online shopping, smart phones, social media, software-as-a-service, the cloud, the lithium battery, electric vehicles, electric everything, the Internet of Things, machine learning, artificial intelligence… Some are even putting faith in something called the “metaverse”.
The common theme amongst these companies as they set out on their early paths is growth in revenues, with ongoing reinvestment assuring earnings may still be some time away. In other words, cash flows are “longer-duration” – somewhere out in the future.
Short-duration cash flows are reserved for the dinosaurs of yesteryear – familiar industries that existed in the twenty century but are still alive today, from banks to miners, supermarkets to manufacturing. These stocks are typically boring plodders offering gradual capital appreciation and low but stable returns through reliable dividends. Yet-to-profit growth stocks don’t pay dividends.
These companies offer short-duration cash flows and, assuming they’re not about to be relegated to history, “value”, if they have been overlooked by investors.
We could make the case that many of this century’s runaway growth stock success stories would not have been success stories if money wasn’t as good as free, and if future cash flow forecasts were not able to be discounted back to today’s dollars at the lowest of risk-free rates. Hence in 2022, as money once again bears a cost, the music has stopped for the growth sector.
While even the mighty have suffered falls of -25%, -30% or more, some have copped -80%, -90% or more. Complete lifetimes of corporate existence all but wiped out.
Value companies have also suffered in the general bear market, but they’ve seen the ebbs and flows of interest rates over time and are still here to tell the tale. Their lower, but more reliable future returns are discounted at the same risk-free rate, but have far less impact on overall valuation.
Value has spent two decades waiting in the shadows for a renewed moment in the sun.
Not that T. Rowe Price recommends abandoning growth altogether. The asset manager is underweight stocks in general, remaining cautious on the environment for equities given still-aggressive central bank tightening and a weakening outlook for growth and earnings.
But within equities, T. Rowe is “nearly balanced” between value and growth. The slowing economic growth backdrop is unfavourable for cyclicals, while higher rates weigh on growth-oriented equities.
As the November rally has shown, growth stocks can come flying back on the slightest hint of light at the end of the rate hike tunnel. Growth is not dead (just pining for the fjords).
Follow the Leader
We recall that Morgan Stanley believes developed market economies will be “in or near” recession in 2023. For the US specifically, the broker believes the economy will “barely skirt” a recession, but the landing “doesn’t feel soft’”, which harks back to my opening regarding “feeling like” it’s a recession.
Morgan Stanley expects the Fed will maintain a restrictive policy stance for nearly all of 2023, and the lagged impact of the policy will keep GDP growth below the “potential” rate of 1.5% in 2024. The result will be two “very weak” years.
Only in the back half of 2024 will the Fed return (cut) the policy rate toward a neutral level by year-end.
The broker forecasts GDP growth of 0.3% in 2023 and 1.4% in 2024.
That said, Morgan Stanley believes we will now enter the final stages of the US equity bear market, in which “two-way risk” must be respected. At the beginning of November the broker switched to a “tactically” bullish view (correctly as it turns out) but did not suggest the bear market was over.
The “pause before the cut” of policy is typically good for stocks, once the end-game for rates is understood.
Morgan Stanley forecasts a year-end level for the S&P500 of 3900 (it was last at 3941) but sees more volatility through December. Consensus earnings forecasts for 2023 are still “materially” too high in the broker’s view, and is forecasting S&P net earnings to fall -11% year on year. This earnings risk will be acknowledged by the market sometime in the March quarter, sending the S&P down into the 3000-3300 range.
The 2022 low to date is 3491.
The broker then suggests, as is historically typical, the index will trough ahead of the actual earnings trough, and there will follow a sharp rebound to end-2023. Back to 3900.
Might as well have a year off.
Morgan Stanley remains defensively positioned in equities.
Morgan Stanley is not Robinson Crusoe. While there are some on Wall Street who believe the bottom of this bear market has now been seen, the majority continues to write off recent gains as no more than just another, traditional, bear market rally.
Note: 2023 Outlook: Global will shortly be followed by 2023 Outlook: Australia.
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