Every December, we try to come up with predictions for the New Year. We believe these predictions have at least a one in three probability of materializing – making them realistic while not necessarily our base case. We also judge that they are not currently priced in the markets – making them surprises relative to investor positioning.
2022 was chock full of revelations that were identified here first including an ECB, formally perceived as being doomed to negative rates for eternity, hiking not once but four times as well as cash proving to be one of the best-returning asset classes as inflation ballooned and bonds yields surged. As we suspected, central banks that did not fall into the “transitory trap” and hiked pre-emptively and aggressively, like the Banco Central do Brasil (BCB), were able to buck the strong USD trend and provide attractive returns in their local bond markets.
Here are our 2023 predictions:
The Federal Reserve pauses rate hikes in Q1 but comes back in the second half of 2023 to continue raising rates. The consumer is in fine shape: that’s what low unemployment rates and mid-single-digit wage gains are telling us, and that’s before 70 million Americans receive a 9% social security benefit increase on January 1. Combined with still high deposit balances, the consumer has been in a very good position to absorb the higher costs of inflation and rising financing rates. Add to that business balance sheets which are still very strong and state rainy day funds that are burgeoning, and the slowdown we are seeing in some economic data may end up being short-lived. If the tight labor market is a genuine economic reality, wages will continue to climb, helping absorb ongoing price increases and leading to higher levels of consumption. And with a full reopening of China, global aggregate demand will surge again with prices for goods and services rising sharply. In this scenario, the Fed will have little choice but to resume raising rates. The equation is: inflation doesn’t come down until wages do; wages don’t come down until unemployment rises; unemployment doesn’t rise unless we are in recession. Volcker showed us that very high real rates are necessary to kill aggregate final demand and trigger a recession. It is possible the Fed will not initially do enough.
High yield credit spreads widen to 800 bps. The history of high yield spreads going back to the late 1980s is clear. High yield spreads peak in recessions at a minimum of 800 bps. Since 1988, the Fed has gone through 5 rate hiking cycles, which ended in recession 4 times. The only one that did not result in recession was the 1994-1995 cycle which ended in a soft landing. In that period, credit spreads were ~450 bps – roughly where they are today – suggesting that the market is currently pricing in a soft landing. There is a lot of potential spread widening given our recession expectation.
Japan ends Yield Curve Control (YCC) driving 10-year JGB yields to 1% and the yen to 100. Apparently, policy makers are now starting to front run our ‘surprises’! After a nearly 30-year battle with deflation, the Japanese economy finally has some meaningful inflation (3.7% according to the October Nationwide CPI). Nonetheless, the Bank of Japan (BOJ) and Governor Kuroda have been adamant about maintaining YCC and quantitative easing. As the rest of the world continues to normalize policy rates, can the BOJ go it alone? Or will the approaching end of Governor Kuroda’s term in April 2023 give them an opportunity to change direction? An end to YCC will likely lead to a spike in JGB yields and the yen, which may lead to the start of a very long period of capital repatriation. Hopefully, if/when YCC ends, the aftermath will be more orderly than simply watching the mother of all carry trades unwind.
Local emerging market (EM) debt will generate a double-digit positive return. In a U.S.-led recession that results in a weaker U.S. dollar and lower Treasury yields, EM local rates could benefit the most. This is contrary to historical precedent which indicates that as central bank tightening progresses, it pulls the liquidity rug out from under the emerging markets which leads to disorderly price action and a flight of capital. This time, things are sufficiently different: (1) foreign ownership is less than 15% of most markets as local bank and asset manager buying has grown tenfold and (2) EM central banks are far more credible now, having already raised rates from the start of 2021 by a cumulative ~22,000 bps as compared to the developed market central banks at ~3,600 bps. We like the larger economies that have undergone structural changes: Mexico, South Africa and Indonesia. For investors looking for high real yields, a stable ownership base and some currency upside… here it is.
Bitcoin (XBT) bounces 50%. What more can go wrong for an asset/currency that is down ~75% in a year? The exodus of the WFH (work from home) army that supplemented its trading capital with fiscal transfers to help drive XBT higher is largely complete. The cadre of professional investors who touted it, with some suggesting a fair price of 1 bitcoin per unit valued at $400,000 a couple years ago, have gone silent. And the SEC is on the doorstep of trading platforms previously considered as stable. Throw in Congressional hearings, etc. and Bitcoin looks to be sufficiently washed out. With only the true believers remaining, Bitcoin seems to have found a floor and is now vulnerable to the proverbial dead cat bounce.