Despite remaining above central bank targets, inflation should start to moderate as the economy slows, the labour market weakens, supply chain pressures continue to ease and Europe manages to diversify its energy supply.
Our core scenario sees developed economies falling into a mild recession in 2023.
However, both stocks and bonds have pre-empted the macro troubles set to unfold in 2023 and look increasingly attractive, and we are more excited about bonds than we have been in over a decade.
The broad-based sell-off in equity markets has left some stocks with strong earnings potential trading at very low valuations; we think there are opportunities in climate-related stocks and the emerging markets.
We have higher conviction in cheaper stocks which have already priced in a lot of bad news and are offering dependable dividends.
Developed world growth to slow with housing activity bearing the brunt
As we look to 2023 the most important question is actually quite straightforward: will inflation start to behave as economic activity slows? If so, central banks will stop raising rates, and recessions, where they occur, will likely be modest. If inflation does not start to slow, we are looking at an uglier scenario.
Fortunately, we believe there are already convincing signs that inflationary pressures are moderating and will continue to do so in 2023.
Housing markets are, as usual, the first to react to central banks touching the monetary brake. Materially higher new mortgage rates are crimping new housing demand and we think the ripples of weaker housing activity will permeate through the global economy in 2023. Construction will weaken, spending on furniture and other household durables will fall and falling house prices could weigh on consumer spending for the next few quarters. The decline in activity should have the intended effect of taming inflation.
Thankfully, the risks of a deep, housing-led recession of the type experienced in 2008 are low. First, housing construction was relatively subdued for much of the last decade, which means we are unlikely to see a glut of oversupply driving house prices materially lower (Exhibit 1). Second, those that have recently bought at higher prices were still constrained by the banks’ more stringent loan-to-value and loan-to-income ratios.
Exhibit 1: Limited stock of housing for sale should prevent large house price declines
Thousands (LHS); average stocks per surveyor (RHS)
Finally, the impact of higher rates on mortgage holders is likely to be less severe. In the US, households did a good job of locking in the low rates experienced a couple of years ago. Only about 5% of US mortgages are on adjustable rates today, compared with over 20% in 2007. In 2020 the 30-year mortgage rate in the US hit just 2.8%, prompting a flurry of refinancing activity. Unless those individuals seek to move, their disposable income won’t be impacted by the recent increase in interest rates.
In the UK, some households have similarly done a good job of protecting themselves from the near-term hike in rates. In 2005 – the start of the last significant tightening cycle – 70% of mortgages were variable rate. Today, variable rate mortgages account for only 14%. However, a further 25% of mortgages were fixed for only two years. This makes the UK more vulnerable than the US, albeit with a bit of a delay.
It’s also worth remembering that not everyone has a mortgage, while individuals that have cash savings will see their disposable income rise as interest rates increase. This factor is particularly important when thinking about the larger countries in continental Europe, where fewer households have a mortgage, and household savings as a percentage of GDP are higher than in the US and UK (Exhibit 2). The European Central Bank (ECB) was often warned that zero interest rates would be counterproductive because of the degree of savings in the region.
Exhibit 2: The main countries of Europe have less housing debt making them less vulnerable to higher ECB rates
Home ownership by mortgage status
% of households
Europe is weathering the energy crisis well
For Europe, the key risk is less about a housing bust and more about energy supply, given that Russia – the former supplier of 40% of Europe’s gas – stopped the bulk of its supplies this summer.
For the coming winter, at least, the risk to gas supplies is in fact diminishing due to a combination of good judgment and good luck. Europe managed to fill its gas tanks over the summer, largely replacing Russian gas with liquefied natural gas from the US.
Since then, Europe has had the good fortune of a very mild autumn and, as a result, enters the three key winter months with storage tanks that are almost full (Exhibit 3). Unless temperatures turn and we face bitterly cold weather in the first months of 2023, Europe looks increasingly likely to make it through this winter without having to resort to energy rationing.
Exhibit 3: Europe enters the key winter months with full gas tanks
EU natural gas inventories
The gas in storage was, of course, obtained at a very high price. However, governments are to a large extent shielding consumers from the bulk of higher energy prices. We will have to wait to the spring to see whether the cost to the public purse is proving too great for support to continue.
China to open up post Covid, easing global supply chain pressures
The Chinese economy has been faced with an entirely different set of challenges to the developed world with widespread lockdowns still in place to contain the spread of Covid-19. Low levels of vaccination, particularly among the elderly, coupled with a less comprehensive hospital network than in the west, have left the Chinese authorities reluctant to move towards a ‘living with Covid’ policy.
However, a prolonged period of lockdown also appears untenable and we expect China to experience an acceleration in activity as pent-up demand is released. While the timing of policy changes remains uncertain, the market’s performance has highlighted how sensitive investors are to any signs of a shift in approach.
Importantly, normalisation of the Chinese economy could significantly ease the supply chain disruptions that have contributed to rapidly rising goods inflation. Although a rebound in growth in China could also boost demand for global commodities, our assessment is that on balance this is another driver of lower inflation in 2023.
Inflation panic subsides, central banks pause
Signs of slowing activity in the west, and a return to full production in China, should ease inflation through the course of 2023, with the shrinking contributions from energy and goods sectors in particular helping price pressures to moderate in the months ahead.
However, to be sure that we’re out of the inflationary woods, wage pressures also need to ease. This is where the central banks went wrong in assuming inflation would prove “transitory”, as they underestimated the extent to which labour market tightness would result in workers asking for more pay (Exhibit 4).
Exhibit 4: The central bank inflation errors are rooted in the labour markets
Bank of England average weekly earnings forecasts
% change year on year
Job vacancies – which in all major regions still exceed the number of unemployed – will be a key indicator to watch in the next couple of months (Exhibit 5). Job hiring and quits are already rolling over and, given higher pay is one of the most common reasons for people moving jobs, we see this as a sign that wage growth should ease.
Exhibit 5: The labour market is still too hot
Job vacancies versus unemployment
x, vacancies as a multiple of unemployed, relative to average
Assuming headline inflation and wage inflation are easing, we see US interest rates rising to around 4.5%-5.0% in the first quarter of 2023 and stopping there. The ECB is similarly expected to pause at 2.5%-3.0% in the first quarter. The Bank of England may take slightly longer to reach a peak, given that inflation is likely to prove stickier in the UK. We see a peak UK interest rate of 4.0%-4.5% in the second quarter.
Central banks also have ambitions to reduce the size of their balance sheets by engaging in quantitative tightening, but we do not expect a particularly concerted effort, nor any significant disruption. Quantitative easing was designed to give central banks extra control and leverage over long-term interest rates, helping the market to absorb large scale government issuance. We expect quantitative tightening to operate under the same principle and, given bond supply is still expected to be meaningful in size in 2023 – and borrowing costs have already risen meaningfully – we expect central banks to be modest in their ambitions to reduce their balance sheets.
Recessions to be modest
Ultimately, our key judgment is that signs will emerge in the coming months that inflation is responding to weakening activity. Inflation may not be heading back quickly to 2%, but we suspect that the central banks will be happy to pause, so long as inflation is headed in the right direction.
Against this view, there are two types of bearish forecasters. Some still believe we have returned to a 1970s inflation problem, which will require a much deeper recession and much larger rise in unemployment than we expect to drive inflation away.
Others argue that moderate recessions are difficult to engineer because slowdowns take on a life of their own, with a tendency to spiral. This situation has been true in the past, when deep recessions were busts that followed a boom. Following excessive growth in one area of the economy – most commonly business investment or housing – it has often taken a long time for the economy to adjust and find alternative sources of growth. However, this time round, investment and housing growth has been more modest (Exhibit 6).
Exhibit 6: There wasn’t enough of a boom for us to worry about a bust
US residential and business investment
% of nominal GDP
In addition, bouts of excess enthusiasm have usually been fuelled by excessive bank lending, which has historically led to a period of weak credit growth, further compounding the downturn. This time round, however, more than a decade of regulation since the global financial crisis means that the commercial banks come into the current slowdown extremely well capitalised, and they have been thoroughly stress-tested to ensure they can absorb losses without triggering a credit crunch (Exhibit 7).
Exhibit 7: The health of the financial sector should prevent a credit crunch
Core tier 1 capital ratios
%, regulatory tier 1 capital to risk-weighted assets
In short, busts follow booms. But booms were notably absent in the last decade where activity across sectors was, if anything, too sluggish. Although economic activity does need to weaken to be sure inflation moderates, we do not expect a lengthy, or deep, period of contraction. Given the decline already seen in the price of both stocks and bonds, we believe that while 2023 will be a difficult year for economies, the worst of the market volatility is behind us and both stocks and bonds look increasingly attractive.
The six issues likely to have the most impact on global investments in 2023.
Maria Paola Toschi
Maria Paola Toschi