2023 H1: What investors should expect

Due to the spike in interest rates, real estate investors are worried about their returns.

Although it is clear that bond yields are a driver of real estate performance -- and prime transaction yields have been moving up due to higher rates -- investors should know that this is not the most important factor.

As the chart shows, the most important driver of returns is employment growth. Negative employment growth leads to pressure on rental income and a likely increase in vacancies. Employment growth affects both income and valuation: this is reflected by its correlation of 0.68 with real estate returns.

Employment has held up strongly through 2022, underpinning the property sector, but it’s expected to weaken in 2023 – and, therefore, real estate returns might deteriorate as well. If employment growth weakens only lightly, real estate might not suffer as much as some would believe. The opposite will obviously be true should employment growth deteriorate sharply.

In 2022, we saw real interest rates rise and an adjustment in stock valuations in response to the correction of historic monetary easing -- particularly in the U.S.  

In the first half of 2023, we expect a return to normalcy in the asset mix, especially the correlation between bond and stock markets. A slower pace of U.S. interest rate hikes will lead to a rise in risk assets in the short term, including commodities -- a well-known dilemma in an inflationary environment.  

The geopolitical risks between Russia and China and the Western countries have yet to be fully resolved and have a cost-increasing factor -- via commodity prices and supply chain constraints.  

Although we are halfway toward a soft landing in the balance between monetary policy and the slowdown in economic activity, our past experience suggests that the current situation won’t result in a smooth start to the next economic expansion.  

As the extreme pace of interest rate hikes is adjusted, and interest rate volatility is calmed, the next consideration is a greater-than-expected decline in corporate earnings per share in anticipation of a recession. As the following chart shows, we are watching CEOs’ sentiment about the US economy as a key indicator: the Conference Board’s CEO Confidence Index closely tracks changes to forward EPS in the S&P 500, seven months later.

As the shift from stocks to fixed income is realised, US interest rates won’t be increased. Japanese equities will see a relatively large decline in yen terms (the flip side of 2022). This will also coincide with the dollar-yen peak-out.  

We will be paying particular attention to events including the arrival of the terminal U.S. interest rate and the end of the current governor of the Bank of Japan’s term in April.

In our view, three key factors differentiate this cycle from those in recent decades:    

1. Inflation is likely to “stick” around.

Inflation has been largely absent from the U.S. economy since the 1990s; now we expect it to drive the policy outlook and asset allocation choices for the next several years. What will it take for inflation to fall to tolerable levels and stay there? In a word: time – time for restrictive interest rates to filter through and slow the economy; time for policy to soften the labour market and relieve upward pressure on wages. Until then, we expect firmer average inflation.  

‍2. Policy support won’t save the day.

Stubborn inflation may limit policymakers’ ability to support growth next year, even as the U.S. teeters on the brink of recession. The Fed may pause – not pivot – as it works to bring inflation down. The firehose of policy support that was quantitative easing has now become a liquidity drain. And appetite for fiscal spending has faded – due both to the understanding that spending has been a key culprit in today’s inflationary environment, and to increasing concerns about debt sustainability.  

3. The geopolitical risk premium is elevated.

The driving force behind decades of globalisation has been the reduction of costs. But as the past two years have made painfully clear, “globalised” supply chains can create concentrated sources of risk. Concentration of global semiconductor and vaccine production involves the smallest of components – from disposable gloves and glass vials to batteries – but contributes to a much larger reality: for sensitive industries, including tech, medicine, food, defense, and energy, globalisation can create national vulnerabilities. As risks (and costs) rise for companies, the prices they demand may rise as well. Investors, for their part, may require more compensation (higher yields) for the risk taken.

A key uncertainty for 2023 is whether the world’s biggest economy, the United States, will experience a recession. In an earlier note in May, we used the yield curve as well as other market and fundamental-based measures to estimate the probability of a recession over the subsequent 12 months.  

At that time, the chance of recession was low, but was starting to look more plausible two years out. Subsequent developments – not least the Federal Reserve’s 300 basis points of rate rises – make this exercise worth revisiting.  

Our updated daily estimates now point to a recession next year, as the first chart shows. This could soon be reaffirmed in future updates to the New York Fed’s monthly measure of recession probability.

A recession has increasingly come into view with the Fed taking rates into restrictive territory. Market pricing suggests that by Q3 2023, the stance of monetary policy as proxied by the interest rate gap – the difference between actual and neutral rates – might be the tightest in 40 years, as the second chart shows. The early 1980s was also the last time inflation was this high.  

With the gap typically peaking just ahead of a recession (the green dots in the second chart), this also points to the potential for a recession later next year. The gap does, however, occasionally provide a false recession signal (the orange dots), hence the uncertainty.   

Central banks are expected to continue to raise rates as inflation data has yet to cool sufficiently to allow them to slow their pace of tightening.  As rates get firmly into restrictive territory – where we will be shortly in our view – and as financial conditions tighten, the markets are going to look for some clarity from global central banks as to where things are headed next.  

In other words, it is time for some forward guidance.  Forward guidance is a tool to help markets understand where policy makers are headed and should help reduce uncertainty.  Forward guidance could consist of a set of expectations from the central bank on where they are likely to take policy over the coming quarters.  Forward guidance would give investors a broad idea of where central banks are likely to head.  Currently we have virtually no forward guidance; instead, the Fed has been reacting in real time to inflation data.  

The lack of forward guidance is creating large amounts of investor uncertainty about the path for interest rates, and serves to push up interest rate volatility. Interest rate volatility, in turn, makes it more difficult for investors throughout the global economy to plan and invest in the face of an uncertain discount rate.  Since the US is the global reserve currency, US interest rate volatility has a large impact on investment decisions made the world over.  

Recent market events in the UK serve as an example of the types of dislocations that can come with increasing interest-rate volatility.  In the case of the UK, uncertainty around monetary policy paths was amplified by instability in the government and surprising fiscal easing through tax cuts and energy subsidies. The combination of fiscal and monetary uncertainty created massive volatility in the UK gilt (government bond) market. The rise in yields and volatility in the Gilt market created further disruption as UK pension funds were forced to raise cash to meet margin calls on their interest rate hedges.  

Higher yields are, in aggregate, a positive for long-term investors like pension funds. It’s just the speed and extent of the move that created such dislocations.  While most other pension systems are not susceptible to such a margin squeeze, it is emblematic of the problems investors can face from high and rising interest rate volatility.  High government bond volatility will have impacts well beyond the government bond market itself.

Central banks have been successful in resetting the level of interest rates and have now tightened financial conditions into restrictive territory in our view.  This will go a long way to ensuring long-term inflation remains under control.  A byproduct of this has been an increase in investor uncertainty and market volatility.  Markets have successfully managed through this volatility so far, but sustained high levels of volatility, particularly in longer term interest rates, may start to negatively impact investment decision making.  Forward guidance from the monetary authorities would be a constructive step toward containing volatility.

The past year has been characterized by the capitulation of developed market central banks and bond investors after being deeply wrongfooted on inflation. The latter was rooted in misplaced macro narratives, including some variant of secular stagnation.  

The capitulation process is not complete but will ebb over the next several months as measured consumer price inflation erodes. This should allow G7 bond markets to temporarily calm and provide a window for risk assets to firm, albeit within the context of a mature economic and investment cycle.

Subdued economic growth during the 2010s was not structural in nature, but rather the result of powerful deleveraging drags from households and banks in the U.S. and euro area, two major sources of final demand and key global price setters. With these drags over, underlying activity will prove more resilient and less vulnerable to higher borrowing rates than the consensus fears.

Likewise, the anchoring of consumer price inflation last decade was caused by sluggish demand, massive production and labour market slack, as well as ongoing drags from globalisation and technology. These anchors began to lift prior to the pandemic and will not return meaningfully even in the event of a recession. Inflation will ease in the coming months, but underlying price pressures will prove stickier than implied by longer-term market-based inflation expectations.

The prevailing view in financial markets has long been that the Reserve Bank of Australia (RBA) cannot have an overnight cash rate too different from that of the US Federal Reserve. This view is now being tested. The RBA is slowing its rate rises and taking a break over the Southern Hemisphere summer, while the Fed is expected to deliver more outsized rate rises.  

We expect the RBA to take its overnight cash rate to 3.6% by March, while the Fed pushes past 5% by early 2023, as our first chart shows. There are some important reasons for this divergence.

First, the prevalence of variable and short-term fixed-rate mortgages (2-4 years) in Australia means the RBA has a more powerful monetary policy transmission mechanism than the Fed, which must influence the yield curve in order to shift long-term mortgage rates. Even then, the Fed only really influences the flow of new mortgages, rather than the whole mortgage stock.

The second core reason is the prevailing difference between price increases for services in the two nations, as demonstrated by the next chart. Australian services inflation has picked up recently, but remains well below that of the US – where 50% of overall inflation is being driven by high and sticky services inflation. We expect this means that the Fed will stay restrictive for some time.

One question we often asked is how this difference in terminal rates plays for a small, open economy like Australia. A depreciation of the currency is the most direct impact, and this can make the inflationary problem worse as imports get more expensive. While we have seen AUD/USD depreciation in 2022,  Australia’s Import Trade Weighted Index (TWI) is the indicator that really matters for import inflation. The following chart indicates this divergence.

At this point, the RBA does not seem all that worried about higher imported inflation. The resilience of the TWI in 2022 (as our final chart shows) is one factor giving the central bank confidence, and as long as this remains the case, it’s unlikely that the RBA will be overly influenced by other central banks’ decision-making.

That’s another key reason we predict a persistent difference in the terminal interest rate for the US and Australia. The AUD may end up being more important as an automatic stabiliser for the real economy should a global recession emerge.

Next year we are likely to see stronger net inflows to USD bonds from Japanese investors. That will help drive down yields once the Fed pauses the current hiking cycle, and marks a contrast to the large net outflows in 2022 (shown in Chart 1).  

In Japan, hedges are widely used to prevent currency losses. They convert USD yields into a “hedged yield” in yen – which, as  Chart 2 shows, that plunged into negative territory this year. The driver was a rise in the FX hedge cost, driven by the wider US-Japan interest rate differential.  

Many investors have discussed publicly how the US debt sales were driven by the double whammy of higher US rates, and the rise in FX hedge costs. However, in the long run, US bond portfolios will still be needed to offset Japan’s low-yielding domestic assets. On top of that, Japanese household assets have swelled to about USD 14 trillion – close to a record high.  

Thus, USD bond appetite should resume – at about the same time as rate and FX hedge cost outlooks improve, when investors are convinced that the Fed hikes will stop.

Emerging market fixed income assets have the potential to generate significant returns as investors step into 2023. Three catalysts underpin our constructive view.  

First, monetary policy is shifting. The market anticipates the Federal Reserve (the “Fed”) and the European Central Bank (the “ECB”) will pivot, moving from policy focused on taming inflation to considering growth.  The ECB stressed data dependency and made dovish statements alongside its 75-basis-point increase in November. The Fed raised interest rates by a similar amount, but highlighted the lagging effects of accumulated tightening.   

Central banks are encouraged by recent economic numbers. For instance, October’s CPI print was below consensus, with core measures showing signs of moderation.  Moreover, U.S. midterm elections resulted in a return to a divided government – which will likely constrain spending and reduce pressure for more monetary policy tightening.   

Secondly, China is paving the way for some sort of reopening by mid-2023, removing a key dampener on emerging markets. Chinese financial assets represented a major drag on EM returns over the last half of the year, driven largely by the country’s real-estate corporates – a sector disproportionately hurt by lockdowns and broader deleveraging policies. Within the context of historically low valuations for Chinese assets, an easing in pandemic restrictions and support for developers could provide an additional impetus to EM assets.   

Third, carry in EM fixed income is attractive, supported by proactive central bank tightening and corporate spreads that are above historical averages. For local bonds (the GBI-EM Index) and high-yield USD corporates (the CEMBI HY+ index), yields currently stand at 7.3% and 11.3%, respectively. Another constructive component: positioning. Outflows from hard-currency emerging market bond funds this year are more than $42 billion – surpassing outflows during the crisis year of 2008.  

With such significant outflows in emerging market debt and attractive carry, the door is open for reallocation to the asset class in the year ahead.  

The yield on the three-month Treasury bill is now 0.72% above that of its 10-year counterpart, as this chart shows. That’s the deepest inversion in the last two decades – deeper than in 2006/07. This inversion is a strong and historically accurate signal of a near-term recession.  

In fact, researchers unanimously regard this as among the most solid indicators that a U.S. recession is due on a six– to 18-month time horizon. It’s called every recession in recent decades, with no false positives.  

While a downturn is basically set in stone, experts continue to debate whether the term “recession” will be fitting. We believe that the U.S. economy will more than likely enter recession in coming quarters, albeit a significantly milder one than faced in Europe, which is more dependent on energy imports.

As the above illustration indicates, housing inventory (as expressed by the ratio of new houses for sale versus new houses sold) is on the rise. We are experiencing a significant discrepancy between supply and price in the US real estate sector.  

Given the sometimes illiquid nature of the housing market, such divergences are not unheard of, but historically prices catch up – or, rather, down.  

The lack of confluence is mainly due to the US prevalence of fixed-rate mortgages. Debt-servicing-costs are thus not influenced by the rapid interest-rate increases we have seen in 2022.  

The catalyst for a rapid price decline might be weakness in the labour market. If people start getting laid off, which is our base-case scenario for 2023, watch for forced sales and foreclosures.

Our models suggest a 15-20% decline in the BIS Residential Price Index is probable, as our final chart shows.  

Given the fact that housing accounts for 15-18% of GDP, according to the National Association of Home Builders, it remains the main driver of the US economy. Based on household debt and savings, lending rules and other parameters, we are not predicting as big a shock to the real estate market as was seen in the financial crisis of ’08.  

This doesn’t imply that we don’t predict a correction or reversal to the mean. We see a rapid surge in supply because demand is being suppressed by the increasing cost of capital: interest and mortgage rates.  

As the average loan-to-value ratio on home purchase loans at origin touched 84.5% at its peak in 2020, we could face a scenario in which people’s liabilities outweigh their equity, leaving them insolvent once the price of their home – almost inevitably – comes down.  

The drawdowns by equity and crypto markets are hence likely to spread to global real estate in 2023 as a natural consequence of unemployment picking up.

The outlook for GCC nations in 2023 remains constructive after a strong performance in 2022. Economic growth will slow as the sharp increase in hydrocarbon-related gross domestic product seen this year is unlikely to be repeated. Further production cuts from OPEC+ also pose a downside risk to growth.

However, non-oil GDP is likely to remain relatively robust as governments continue to invest in strategic sectors and projects to diversify their economies. Emirates NBD’s baseline forecast is for oil to remain above USD 100 per barrel next year, which will allow GCC governments to maintain spending even as private investment slows.

There are headwinds to growth in the coming year, however. The region is not immune from slowing global growth, particularly given its position as a trade and logistics hub.  Higher borrowing costs may deter private sector investment and a strong US dollar will also erode competitiveness, making the region a more expensive destination for both foreign investors and tourists.

Allocations to equities have a strong correlation with stock returns over the following ten years, as our chart shows. And, ominously, there are only two periods where American investors’ allocation to equities has topped 55%: the dotcom bubble and December 2021.  

Conversely, shortly after the financial crisis, the allocation to equities was very low: below 20%. That set the stage for a decade of very good returns.

The fact that both domestic and international investors are more than fully invested in US stocks, especially tech-related companies – at a time where good alternatives are present, in the form of international equities and bonds globally – will probably mean a critical lack of buyers going forward. It’s less likely that there will be a shortage of prospective sellers.

Meanwhile, 2023 will see the persistence of a more inflationary world as “hyper-globalisation” ends and workforces age.  

The fall of the Berlin Wall and China’s entry into the World Trade Organization set the stage for 25 years of declining prices for consumer goods. That era is over.

Wages have caught up: profits from international outsourcing are reduced. Supply chain reshoring is gaining ground.  

Furthermore, the global labour supply is shrinking and the cost of living is pushing down birth rates. Dependency ratios (people younger than 16 and older than 64, divided by those between 16 and 64) are increasing rapidly in nations from China to Mexico. Most of Europe is affected too; the US and UK less so. The only part of the world where dependency ratios will remain low and population growth will be strong is Africa (Nigeria might match China’s population sooner than we think). Power will shift from employers to employees.

Investors should prepare for a world of higher inflation as commodity prices rise, international tensions spike and populations age.

While recession indicators are flashing for 2023, interest rates are still climbing. The inflation-fighting army of central banks,, led by the US Federal Reserve, is set for the most hawkish policy seen in decades.

Chairman Powell has indicated that the Fed is on a mission to get rates higher than inflation. For many central banks, their key policy rate is still well below the inflation rate. Meanwhile, longer-dated rates are significantly higher than breakeven inflation on similar maturities.

Furthermore, tight monetary policy has driven 10-year real rates far above their 25-year trend, as the next chart shows. Current values exceed the historic trend by more than three standard deviations.  

Along with surging energy prices, this has been a primary source of ongoing (and expected future) demand destruction.

This explosive move in interest rates is massively disconnected from the business cycle.  

The most pronounced disconnect is between the Institute for Supply Management (ISM) manufacturing index and changes in the 10-year interest rate, as the next chart shows. The gap is at its biggest in several decades. And there is no time in recent history where the two indicators have been moving in different directions for as long as they have in 2022.

Central banks are at risk of overtightening, moving down a path that’s inappropriate given trends in the business cycle. Therefore, as inflation slows materially, expect interest rates to fall off a cliff from the second half of 2023 into 2024. The Fed could ease by as much as 300 basis points.  

Consensus seems to view this market as a bear and, indeed, it qualifies as a bear. Or does it?  

In broad terms, the consensus view has shifted. Many expect a recession in the US and Europe in 2023, combined with a decline in corporate earnings. This scenario would see  the S&P 500 enter phase two of the bear market, declining between 35 percent and 40 percent from the December 2021 high.  

While this path may be followed, it seems increasingly at odds with what financial markets are signalling.  

Forward curves have priced in Fed rate hikes to 5 percent, as the chart below shows. The term structure of the US yield curve is inverted – with short rates around 50 basis points higher than 10-year yields.  

Many point out that an inverted yield curve is a sure sign of an impending recession. Some are even worried about a depression, with calls for the Fed to allow rates to decline. Concerns are expressed that liquidity conditions are tight, with credit spreads widening and interbank liquidity strained.  

Accepting that the Fed may tighten up to 5 percent, and keep its key rate well above 4 percent for the next two to three years, would equity markets make their own “pivot,” driving price-earnings multiples higher?  

The answer, paradoxically, lies in how one views duration – the sensitivity to changes in interest rates. With real rates stabilising and US inflation expected to decline in 2023, the benefit will surely accrue to longer duration equities, particularly those that have been hammered the most over the past ten months. In a world of lower inflation and stable real rates, long- duration assets are likely to outperform.

We remain positive on the Gulf Cooperation Council (GCC) economies, despite forecasting a deceleration in real GDP growth in 2023.  

There could be further downside risks to hydrocarbon prices, which in turn could lead to more output cuts. However, there remain both upside and downside risks to the oil price. Slower headline growth in the GCC will largely be on the back of weaker oil sector growth, after a strong pace of expansion in 2022.  

We also see non-oil headwinds increasing, especially for the externally facing service sector, given the deteriorating global backdrop and the strong outlook for the US dollar. Moreover, higher interest rates in the GCC will dampen domestic demand.  

Nevertheless, we remain optimistic about the GCC, given the policy focus on structural reforms, investment to deepen the GCC economies and better management of the oil windfall so far. We see overall stronger growth in the GCC than most other regions.

For the current bear market to turn into a sustainable bull market, a combination of factors is needed.  

First, inflation needs to cool sufficiently for monetary policy to turn dovish. This will lower nominal and real yields, leading to increased purchasing power and reduced financing costs. This, in turn, could boost economic growth.  

While inflation will almost certainly fade in 2023, the process is unlikely to be linear. This implies continued uncertainty around monetary policy, supporting market volatility.  

Given current valuation levels, it appears investors are expecting a benign normalization of inflation, rate cuts and a soft landing. Considering the current elevated recession risk, this leaves markets vulnerable to negative surprises.

Central banks are set to slow the pace of interest-rate increases, but that will be more about responding to weak economies than making strong progress on lowering inflation.  

One important signal that a recession might already be underway is the leading indicator for the world economy produced by the Organization for Economic Cooperation and Development (OECD).  

A drop in the OECD index below 99 tends to happen right around the start of a global recession: in early 2020, early 2008, early 2001, late 1990, late 1981, mid-1974, and mid-1970. We even saw this indicator do a double-dip below 99 before recovering after the recessions in the early 1990s and early 2000s, as you can see in the chart below.  

It’s a repeating story – and it’s below 99 again, signaling another potential recessionary period.

The economic recession could turn into an earnings recession in the first half of 2023.  

After initially proving resilient to the downturn, the global manufacturing Purchasing Managers Index (PMI) is now below 50—the threshold between expansion and contraction—and is pointing to a potential decline in earnings for global companies in the coming quarters.  

If the downtrend continues, it could mean stocks’ price-to-earnings ratios are not as reasonable as they may currently seem.

An immensely important development in 2022 was the phenomenal increase in the euro swap rate, both on the long end and the short end. The graph below charts the relationship between the two-year euro swap rate (the horizontal axis) and the 20-year rate (the vertical axis).  

The green line tracks 2022, and the red line (45 degrees) shows when the 20-year rate is below the two-year rate, which is quite unusual.  

That’s where we are now. This was also the case in mid-2008, during the global financial crisis.

You can see different cycles in this chart, and, indeed different macro regimes.  

In June 2008, the curve is inverted. We then begin a long decline in rates, with short rates going negative during 2015 and long rates going negative in 2020. We started this year with the short rate still negative. , but have moved very quickly and both rates are above 2 percent.

The reason this is an important chart is that our pension fund liabilities are discounted with the euro swap curve. The move this year has been very significant and means funding ratios have greatly improved, despite losses on the asset side of the balance sheet. Liabilities simply declined faster.  

Looking ahead to next year, starting on the “trouble” side of the red line, there are several scenarios.

My base case is that we leave the inverted curve and move back to the north-west side of the 45-degree line – the 20-year swap rate will once again exceed the two-year rate. Like 2008, this may involve a recession in the euro area; this suggests we will move to the left, rather than up, to cross the line.  

There is a risk of a tougher scenario: inflation proves sticky, and we go further north-east. Good for pension funding ratios, but not so great for asset returns.

In 2022, the vast majority of developed market central banks significantly tightened policy as they sought to address broad-based inflation. With most of this adjustment in the rearview mirror, 2023 will be the year in which the full impact of global policy tightening will be felt in force, with growth slowing and inflation moderating. 

In light of this view, what follows are three themes that serve as a template for this challenging outlook, with specific application to the US. Overall, we see a meaningful moderation in headline and core inflation in 2023, but it won’t happen quickly enough to stave off further policy tightening through the first quarter. Inflation moderation also won’t be significant enough to allow the Fed to pivot to rate cuts quickly thereafter. We continue to view a recession, beginning around the middle of 2023, as our base case. With policy remaining restrictive for some time thereafter, the subsequent recovery is likely to be sluggish.  ‍

1. Resilient growth only increases the Fed’s resolve  

Despite meaningful tightening to date, what has clouded the outlook for many investors is the lack of obvious imbalances that would tip the economy into a recession.  In markets, there are few signs of asset bubbles and associated contagion risks, especially after the decline by the S&P 500 this year.  Meanwhile, household and corporate balance sheets remain healthy. Not only do leverage levels appear manageable, but two years of rock-bottom interest rates have allowed households and businesses to lock in lower financing costs. In addition, many households still have excess savings that accrued during the pandemic.  Finally, increasing signs of disinflation suggest that real household income may begin to rise again after largely stagnating in 2022, a development that could further support spending in the near term.

None of the above, however, is reason for optimism. With inflation remaining above the Fed’s 2 percent inflation objective throughout 2023, resilience only means that monetary policy needs to work even harder to slow the economy and bring down inflation on a sustained basis. This is why the Fed's signaling of a policy rate of at least 5 percent looks quite durable. If anything, most standard policy rules suggest that it is the bare minimum that the Fed will need to do to slow the economy.  

Resilient household and corporate balance sheets and a still-strong labor market may keep the economy on a solid footing, but only for so long.  

As the next chart shows, two years of low rates have made household balance sheets more resilient to Fed tightening.  

2. Services inflation holds the key

The easing of global supply-chain bottlenecks, increasing manufacturing output, and the ongoing post-pandemic reorientation of household spending back towards services all suggest deflation for goods prices in the year ahead. But this will not be enough to return inflation to 2 percent on a sustained basis.  

Ultimately, core services inflation will need to moderate significantly as well. There is some encouraging news on this front. Market rents are beginning to moderate, and this will gradually feed through to lower shelter inflation over the course of next year. The outlook for core services inflation excluding rent of shelter, however, is murkier.  

Historically, overall core services inflation is closely tied to the business cycle and the labor market. The Fed is working under the assumption that it will need to meaningfully cool the labor market in order to reduce services inflation to a level consistent with its price stability objective. This is another reason why continued policy tightening and elevated recession risks remain our base case for next year.  

As the next chart shows, history suggests that services inflation may not moderate without a higher unemployment rate.  

3. The lessons of the Great Inflation

The Great Inflation of the 1970s and the Fed’s policy mistakes are deeply rooted in the central bank’s institutional memory. One key lesson of that era is the importance of expectations in shaping outcomes. During periods of persistently high inflation, households and businesses are likely to incorporate expectations of further significant price increases into their spending, saving and investment decisions.

Thus far, it appears the Fed’s forceful policy actions this year have kept medium- and long-term inflation expectations relatively well-anchored. For this to continue, the Fed needs to ensure that inflation returns to the 2 percent objective before long. Hence, their focus on achieving a “sufficiently restrictive” policy stance over the coming months.

This leads to a second important lesson from the Great Inflation – namely, that when inflation is high, the Fed should avoid pivoting quickly to rate cuts when growth weakens and unemployment rises. With the benefit of hindsight, Chairman Burns’ rate cuts following the 1973 recession prevented a sustainable moderation of inflation and likely contributed to an un-anchoring of inflation expectations as the decade progressed.  

Chairman Volcker’s brief period of rate cuts following the 1980 recession might also have been a mistake. As inflation stayed stubbornly high, the Fed was forced to resume raising rates, leading to a second recession less than a year later.  To put the inflation genie back in the bottle, Volcker then kept the policy rate above the rate of core inflation for the rest of his tenure.  

The implications of the Great Inflation are clear for today’s policy makers. First, act forcefully to keep inflation expectations well-anchored. This has largely been accomplished. Now comes the harder part: maintaining restrictive policy even if the economy contracts and unemployment rises.  Having been slow to react to inflationary pressures last year and early this year, the Fed won’t compound this error with a premature exit from restrictive policy.  

As such, if the economy indeed falls into a contraction next year, the Fed’s hands may still be tied by elevated inflation and the lessons of the Great Inflation. If so, the contraction may be deeper than investors currently assume.

After a year of devaluation against the US dollar, we see scope for respite for Asian currencies as several factors come together.  

First, the US Federal Reserve, which has been a major driver of foreign-exchange volatility in 2022, is getting closer to the end of its hiking cycle. The Fed just hiked by another 50bps to 4.25-4.50%. and markets are pricing in about another 25 to 50 basis points in the first quarter of next year – after which the Fed will likely pause for a while.  

This means that most of the upside pressure on interest rates and the dollar is likely behind us, which should provide some relief for global currency markets.  

Second, we expect much greater stability for the Chinese yuan, which will provide an anchor for Asian currencies.  

Indeed, following the yuan’s depreciation of about 9 percent this year, policymakers in Beijing will likely put more emphasis on currency stability. At the same time, a more attractive valuation for the currency and stronger growth will also provide support.  

Third, real yields, while still negative in many Asian economies, are starting to narrow, as the next chart shows. Central banks are hiking more aggressively in response to elevated inflation – after being slow to start their hiking cycles compared to other economies. This should provide support to their currencies in 2023.  

Lastly, while exports will likely weaken for the region as global growth slows, we believe that current account dynamics will remain relatively supported. Indeed, a slight easing of energy prices will help reduce the import bill for major energy importers, such as Japan and India, that have seen their external balances worsen in recent quarters.  

After a tough year for emerging markets, there are some reasons for optimism heading into 2023.  

Investors have a light position overall in the asset class. There is a general easing in US financial conditions. And emerging markets have a more robust growth outlook than developed markets.

However, for Central and Eastern Europe (CEE) in particular, the descent from peak inflation and peak interest rates will be a dangerous one. Weak (bordering on recessionary) growth rates across the region, stilted easing cycles and the fog of war create a challenging climate for asset markets in the region.  

As the chart shows, the key issue for CEE in 2022 has been worsening terms of trade, given surging energy prices. This has led to a return of significant twin deficits for most in the region.  

Terms of trade have recovered since the summer as gas prices have eased and storage facilities have been filled in Europe. However, the energy story is likely to remain an important driver given the chilly temperatures in the coming weeks and, longer term, concerns about the winter of 2023-24. The impact will not be uniform: Hungary and Serbia are most reliant on fuel imports, while Romania is less exposed.

A new era for global production

International trade has increased dramatically for two centuries because of a powerful force: efficiency. But this tendency is not bulletproof. Trade decreased between the start of WWI and the end of WWII, and it has been on the decline since 2011.

The downturn was worsened by political issues, such as Brexit and US-China tensions, and exacerbated by the pandemic, which created bottlenecks in global supply chains. That resulted in skyrocketing transport prices and delays in production.  

The pandemic's lessons differ from the other headwinds. It revealed the trade system’s hidden weakness: the lack of resilience.  

More companies are pursuing strategies to bring production closer to the final consumer, such as onshoring and nearshoring. A survey by HSBC in November showed 89% of firms plan to transform their supply chain in the future, and 42% wanted to execute changes in 2023. Another analysis, from Bloomberg, found that 181 public companies mentioned the terms “nearshoring.” “reshoring” or “onshoring'' in second-quarter earnings calls and presentations. In the first quarter of 2020, when bottlenecks were not yet a major issue, only 15 companies did so.  

The increasing importance of resilience means that with any given set of inputs, the world will produce less than before. Put another way, global production becomes less efficient.  

Some nations stand to benefit from this trend, while others will not. China probably stands to lose, given its lack of political affinity with the developed world and its geographic distance from those markets.  

The opposite holds true for Mexico. Its global trade has expanded while shrinking for nations including China, India, and Indonesia.

‍Nearshoring to Mexico

America’s southern neighbour is well integrated into the global production chain. Therefore, Mexican exports have grown hand in hand with increased input imports.

Mexican manufacturing has outperformed the nation’s GDP growth over the past three years. Mexico’s share of US imports has risen, while China’s market share has declined.  

A survey by Banco de Mexico found that 16% of the nation’s firms with 100 or more employees observed either higher demand for their products and services or increased foreign investment because of nearshoring in the last 12 months. Most of these firms were in the manufacturing sector. These benefits appear to be concentrated in the US-adjacent north of Mexico.

That said, for Mexico to continue capitalising on this opportunity, domestic policies will be key. Insecurity and a lack of rule of law could limit the benefits, as well as an escalation of ongoing trade disputes with the U.S.  

There is no agreement on whether efforts to make production more resilient will last two, ten, or thirty years.  

But the reshuffling of the global supply chain is probably part of the reason that Mexico’s GDP has surprised the market and analysts on the upside so far this year.  

And in this context, although the global deceleration will present headwinds to growth, Mexico’s economy could be more dynamic than most developed and emerging markets in 2023.  

The risks are skewed to the downside as we approach 2023, and U.S. unemployment is likely to rise.  

The goal of economic policy is to help balance supply and demand. Equilibriums are stable situations. Imbalances create inflation.  

Unfortunately, it has been very difficult to achieve this balance – not just in the US, but in many economies over the past three years. There have been very large global shocks, including the pandemic and geopolitical events. Demand in excess of supply has generated the largest inflation concern in the US for the 40 years.  

The Federal Reserve, by mandate, is tasked with fighting inflation. But the Fed does not control the supply side of the economy – only demand. If supply will not rise to meet demand, then demand must fall to meet supply.  

Bringing demand down, when extreme, is another way of saying the economy will be in recession.  

There are several cushions that could help limit the damage in 2023. Excess cash savings are left over from the pandemic-era fiscal stimulus.  

Additionally, the U.S. labor market is tight, as the next chart shows. There are nearly two job openings for every unemployed person. The Fed’s hope is that it can destroy job openings before destroying too many jobs.  

History teaches us that there should be a symmetry to the inflation process: i.e., the steeper the increase in price pressures, the steeper the decline. While there are idiosyncratic events that could matter in the short run (e.g., oil-price volatility), this trend should be the underlying pattern in 2023.  

Eventually the Fed should feel less urgency. That’s key for getting past the downside risk to economic growth and corporate earnings – but we’re still waiting.  

As rates have risen aggressively and balance sheets have started to shrink, economic growth has shifted and is now below potential. To be successful in curbing inflation, central bankers are slowing the economy and likely engineering a recession next year. It's an interesting time to ask: where could growth come from in 2023?  

Consumption is a function of both the willingness and ability of households to spend.  And deteriorating consumer confidence hints that spending is looking less appealing in coming quarters.  

The ability to spend, on the other hand, is a function of wealth and income. Home prices, a good proxy for household wealth, have already contracted 3.3 percent and 7.7 percent respectively in the U.S. and in Canada, and it’s reasonable to expect more headwinds in 2023.  

Income is also no longer able to support consumption. Inflation – especially for food, housing, and transportation – has put a severe dent in most households’ real disposable income, which has dipped below the long-term trend. The picture looks the same for wages: nominal wages have been going up, but inflation is pushing real wage growth into negative territory.  

The hurdle rate (minimum rate of return) for private investments increases with rising interest rates. So when rates and uncertainty are rising, businesses tend to delay capital expenditures. The following chart shows that business confidence surveys are currently pointing to very little appetite for expansion over the coming 12 to 18 months.  

The third piece of the GDP equation is government spending. And it’s limited by both the rising cost of servicing debt and the accumulated stock of debt.  

The last piece is net exports. The story in the US is simple: the dollar has reached historic highs, reducing the competitiveness of US-produced goods and services. The situation in Canada and Europe is slightly different, as currency weakness acts as a competitive advantage. But the overall weakness of the global economy limits the demand for exported goods and services.

So, we ask again: where will growth come from in 2023?

Among Asian currencies, the Thai baht may appreciate the most against the dollar in 2023.  

The Federal Reserve has already hinted that it will be less hawkish in 2023, and the era of a strong dollar has ended, as we see in the first chart. We are now in the very initial stages of a weak dollar, and we expect this trend will gradually accelerate in 2023.  

Compared with other Asian economies, Thailand is more dependent on tourism, which accounts for about 12 percent of its GDP.

As “Living With Covid” rather than restricting movement spreads across the world, the number of foreign arrivals in Thailand has been increasing, as the next chart shows.  

The tourism revival has has also helped Thailand’s current account return to surplus after the long-lasting deficit in the pandemic period, as the final chart shows.

Even China is easing its Covid-zero policy, and further relaxation should be anticipated. With cross border travel eased, Thailand stands to benefit.  

In summary, the factors that made the baht depreciate against the dollar this year have gone into reverse. Expect buying pressure on the Thai currency.

On the surface, the global economy has resisted recent fierce headwinds.

Despite Russia’s war on Ukraine, exploding energy prices and inflation, dramatic monetary tightening and supply chains that are still strained, global GDP has increased 3.5 percent in the first three quarters of 2022 versus the same period last year.

For once, the Eurozone surprised on the upside, while China suffered from its destructive Covid zero policy.

Manufacturing also performed strongly in this challenging environment. Global production increased 3 percent compared with the same period last year.‍

Significant slowdown around the corner

There were good reasons to expect a reasonably strong first half of 2022 and a significant slowdown during the second half. The relaxation of Covid-19 restrictions early this year boosted household services consumption. Companies’ stockpiles were full, while financial conditions were still fairly generous.

What can we expect from 2023?

- The full impact of monetary tightening comes with a substantial lag, and will take a big chunk out of the global economy next year.

- Furthermore, business cycle indicators have deteriorated sharply in recent months, implying a rapid slowdown was already taking place in late 2022, which in turn.

- suggests a weak overhang into 2023.

We should be careful not to interpret the level of indicators literally, but the direction and slope of the curves are significant: the outlook for the global economy has darkened substantially lately.

We expect global GDP to grow by 1.5 percent next year. That might seem to be a decent outcome, but annual growth has only been weaker than this on five occasions since 1960.

This forecast implies another year of sub-potential global growth – we estimate global potential GDP growth at approximately 2.5 percent - after two consecutive recovery years. ”The New Normal” of slow underlying global growth is obviously here to stay!

The Federal Reserve's fight against inflation has already entered its second stage, as the question about where inflation will peak is making room for the debate about where inflation will ultimately settle in 2023.  

Stock markets across the world have risen from their October lows on hopes that inflation has indeed finally peaked. Goods prices are falling, and the housing sector is slowing. However, core services inflation hit another 40-year high in November, rising by 6.82 percent on the year.  

Looking into next year, commodity (and goods) prices will continue to play less of a role in determining where inflation – and therefore monetary policy – is headed. Persistent services inflation will most likely keep headline inflation above the Fed’s 2 percent target for the next 12 to 16 months.

As we head into the New Year, consensus is once again forecasting US dollar depreciation. A weaker dollar is typically associated with an improved global growth outlook and a risk-on environment; the converse is also true, so it’s understandable why there is a systematic bearish dollar bias to currency forecasts!  

The main rationale for the bearish dollar forecasts is that the Fed is near the end of its tightening cycle and that US rates have peaked. However, sustained depreciation would require the global recession to be led by the US and for interest-rate differentials with the rest of the world – as shown in our first chart – to narrow. Neither dynamic appears likely for the time being.  

Additional tailwinds for the dollar could arise should emerging-market central banks replenish their foreign exchange reserve buffers. As our second chart shows, they  have been run down through the FX volatility of the past two years.

Under strain from the escalating cost of money and living, world GDP growth slowed dramatically in 2022. Yet the Gulf, inflated by higher energy prices, enjoyed economic growth of 5 to 8 percent, as well as some of the world’s best-performing stock markets in US dollar terms.

Now, a global recession seems to be fast approaching, with investors focusing on where and when US interest rates will peak. And given the region’s currencies are pegged to the dollar, the Gulf mimics US monetary policy.

For the Gulf’s all-important hydrocarbon receipts not to be hit hard, OPEC+ will have to manage supply effectively. Regional surpluses ballooned in the last 18 months and, in our view, anything above $75 Brent crude is icing on the cake.

The region will not completely ignore global sentiment, but equity and debt investors have the opportunity to participate in extremely ambitious and well-funded expansion plans for the oil and non-oil economies. Spending is set to surge the most in Saudi Arabia, but its neighbours will also deploy considerable wealth.

In a troubled and uncertain world, the Gulf stands out.

The Thai economy has yet to fully recover from the pandemic, despite strong export performance in 2021 and 2022, as tourism (which accounted for about 12 percent of Thailand’s GDP in 2019) remained far below pre-Covid levels.

Looking ahead, we expect Thailand’s economy to be sluggish, uneven, and subject to uncertainties. We forecast GDP growth will slow to 2.8 percent in 2023. It will be important to closely monitor two key issues.

1. Prospects for a global recession:

‍As economies slowed, Thai exports posted year-on-year declines of 4.4 percent and 6 percent for October and November, respectively, as our first chart shows. And as our second chart shows, our forecast (based on the estimated GDP of Thailand's major trading partners) suggests Thai export growth may turn negative for 2023 as a whole under a mild recession scenario.

Should there be a deeper global downturn, there is a high risk of a greater contraction in Thai exports , as we have seen in past economic cycles.

2. Tourism will be a crucial factor for Thailand's economy, exchange rate, and interest rates, as our final chart shows.

Tourist arrivals improved to 1.75 million in November. In our base case, we assume that tourism will drive economic growth in 2023, and expect 19.2 million tourist arrivals.

The expected turnaround in tourism has also supported the Thai baht, despite the dovish monetary policy of the Bank of Thailand.

However, there is still a risk of baht depreciation, particularly during the low season of tourism in Q2 – or if tourism fails to recover as expected. This could further complicate the current monetary policy stance.

Just in time to mark its 10th EU accession anniversary, Croatia accomplished another two important integrational goals at the start of 2023: introduction of the common currency as the 20th eurozone member, and entry into the border-free Schengen zone as its 27th state.  

Croatia had already demonstrated a strong attachment to the single currency. Over half the nation’s deposits and loans were denominated in euros – more than in any country outside the eurozone. The single currency area accounts for slightly over half of Croatia’s external trade and is the source of about two-thirds of the nation’s foreign direct investment and foreign tourists.  

While long-term effects remain to be seen, there is a clear benefit from eliminating foreign-currency risk. An equally important benefit is the European Stability Mechanism umbrella in times of need.  

Furthermore, the single currency and Schengen are expected to boost tourism, a key sector for Croatia. As the first chart shows, tourism has almost caught up with pre-pandemic levels, outpacing the recovery elsewhere in Southern Europe.  

However, further quick wins can already be identified – especially in a tightening global monetary policy environment. Croatia has already benefited from fewer interest rate increases than its non-euro area peers in central and eastern Europe (CEE), as the second chart shows.  

And as the last chart shows, households are sharing the benefits: interest-rate pressures eased, due to the additional liquidity resulting from regulatory changes that accompany euro membership (lower reserve requirements) and lower risk premiums resulting from upgraded credit ratings.  

One can argue that the integration timing was ultimately quite appropriate, given the unfavourable external environment for a small, open economy.

The surge in energy and food prices, coupled with still severe – albeit easing – supply constraints, has dealt a major blow to the global economic outlook.  

While prices for energy and food erode consumers’ real purchasing power, the rise in inflation to 40-year highs in Europe and the US is forcing central banks to tighten monetary policy sharply – at a time when economic growth is already losing momentum.

But it is an unusual downturn. In many respects, fundamentals remain favourable:  

1. Labour demand is close to record levels on both sides of the Atlantic;  
2. Many households can cope with inflation, thanks to their savings;  
3. Most businesses have not built up excess capacity and/or inventories;
4. Governments are stepping up investment; and  
5. Financial institutions are mostly in good health.  

As huge shocks meet supportive fundamentals, the range of potential outcomes is unusually wide.  

While GDP in the Eurozone and the UK may decline noticeably this winter, largely because of the gas-price shock, the US recession in 2023 will likely be shallow.

The labour market and savings rates remain resilient.

For the two decades that I have been active in macroeconomic research and the foreign-exchange and fixed-income markets, market participants – particularly foreign investors – have expressed significant concern about Swedish housing prices.  

Home values have outpaced gains in most other countries for a very long period, and in relation to rents, the price appreciation looks excessive indeed. However, the latter comparison is misguided.

Swedish rents are not set in a context of free markets. Rather, rents are capped and set artificially low (apart from newly constructed homes). The capped rental market is an important reason why Sweden has, relative to population growth, seen weak residential investment over the past 20 years. This has contributed to house price appreciation as demand outstrips supply.

Sweden also continues to provide a tax break on mortgages: a 30 percent deduction on interest-rate payments, making already low rates even lower for the borrower. In an international context, interest payments remain low as a proportion of disposable income, but the level has still doubled in the past 12 months.  

The combination of quickly rising mortgage payments, steep electricity bills and general inflation is having a large, negative impact on private consumption. In the meantime, Sweden remains a country of savers, and the household savings rate remains rather elevated, as our first chart shows.  

As our second chart shows, we are forecasting a 20 percent decline for home prices in 2022 and next year.  

Still, we are less concerned about the long-term consequences of that decline. The labour market is resilient. Interest-rate payments as a proportion of disposable income remain quite low in an international context. Savings are ample.  

The housing downturn is taking prices back to pre-pandemic levels. But the number of households with potentially negative equity in this scenario is low, considering the requirement that buyers fund 15 percent of their house purchases with their own equity. Also, a relatively low number of transactions took place during the pandemic.  

Overall, while home-price trends will be negative for consumption (and GDP, via waning residential investment), the decline will be orderly and not cause to worry about grander, systemic implications.