Richard Maparura
2022 was a memorable year, characterised by high inflation, geopolitical turmoil, and aggressive tightening by major central banks. Stock markets moved in and out of bear market territory throughout the year and, for the first time in market history, bonds and equities both fell by double digits.
Inflation flipped the bond-equity correlation positive, causing an average 60/40 portfolio to record double-digit losses. The bull market that began after the 2008 global financial crisis has come to an end and signals a great reset.
As we head into a new year and a fresh start for performance benchmarks, results from a recent Bloomberg survey show economists believe there is a 70% probability of a mild recession in 2023.
This may turn out to be one of the most anticipated recessions of all time but that does not mean it will not hurt. Bad news, even when expected, often still causes a shock upon arrival.
If unemployment rises, followed by the decline in consumption and companies missing their earnings forecasts, equities and other risky assets may take that badly, regardless of how much the recession was anticipated. This will be worse if inflation remains high, restricting central banks from cutting interest rates.
While consensus expectations point to a mild recession with lingering inflation and tighter-for-longer monetary policy, a contrarian view would forecast one of two extremes: much deeper downturn or Goldilocks returns.
The outlook, however, remains hinged on whether central banks will be able to rein in inflation while keeping economies out of recession. It is hard to see an outcome which would be positive for risky assets.
Either economic growth remains resilient, which would force central banks to keep on tightening, or growth falters and a global recession ensues, both of which are negative for risky assets. This warrants a look at some of the tail risks for 2023.
Mortgage defaults
Households without long-term fixed rate financing will face steep increases in their monthly mortgage payments as interest rates reset higher. Mortgage rates have been rocketing worldwide as central banks hiked rates, causing shocks to consumer spending across major countries.
Any substantial rise in unemployment may also cause defaults as this affects the consumers’ ability to repay mortgages. Also, the continued fall in home prices may incentivise defaults in countries where mortgages do not have full recourse to the borrower.
The higher the rates go, the higher the odds of mortgage defaults and increasing unemployment, resulting in a loop that likely tips global income into a much deeper recession.
There is a significantly greater risk that mortgage shocks may be experienced in the United Kingdom, Norway and New Zealand than in the United States, France, Germany and Italy based on the mortgage structures.
Hawkish central banks
Market participants appear to have priced-in the expectation that central banks are near the end of their rate hikes. However, major central banks are making it clear they still have a long way to go.
Despite slowing down the pace of rate hikes, central banks have indicated that they will remain sufficiently restrictive to ensure a timely return of inflation to the 2% target. In the US, the Fed has indicated that any change in policy will not happen until the labour market weakens.
But, since the labour market is a lagging economic indicator, by the time the labour market data deteriorates meaningfully enough for the Fed to change policy, the global economy may have already slid into a deeper recession than currently anticipated.
Over-tightening monetary policies by central banks present more downside risk to the market’s expectation of a mild recession in 2023.
China’s COVID-19 policy
China’s reopening is unfolding at a surprisingly rapid pace that looks similar to most other countries’ reopening experiences, with accelerating economic growth fuelled by consumer spending and rising inflation. It is not unreasonable to expect a surge in pent-up spending from over a billion consumers after a year of restrictions, aided by soaring excess cash deposit balances.
This could positively translate to an upside risk to earnings estimates for companies with China sales exposure, but more importantly it could also drive a rebound in global inflation for both commodities and goods.
If any surge in consumer spending coincides with moderating global inflation and a pause to central banks’ interest rate hikes, there is a danger that a subsequent resurgence in inflation could dampen market sentiment and overshadow any improvement in the earnings outlook, forcing stocks lower than initially anticipated.
Ukraine war escalates
The market appears to be pricing-in the hope that the intensity of the Ukraine war subsides and perhaps moves towards a negotiated resolution that ends military hostilities.
There are fears that the path to end the fighting may require Ukraine reclaiming Crimea from Russia, something that may prolong the conflict and lead to further escalation by the latter. An escalation by Russia could take the form of further large-scale attacks on civilian infrastructure or restrictions on export capacity through military constraints on the use of shipping routes.
More significantly, it may take the form of using prohibited nuclear, biological or chemical weapons to defend what Russia sees as its territory, drawing other countries into the conflict.
Conclusion
The pre-eminent global concern will be sticky or rising inflation. This will lock central banks in the hawkish corner, meaning persistently higher neutral interest rates, higher cost of capital and lower asset valuations globally. Central banks will be eager to nudge growth below potential to achieve sustainable price stability.
Market opportunities have already reset and investing in 2023 should be more diversified across equities with durable cash flows, quality bonds with significant coupons, and alternatives with volatility-reducing attributes.
Investors should stay defensive, possibly underweight equities, neutral on government bonds, and a cash allocation as dry powder. Should the global recession turn out to be a mild one, there could be an attractive re-entry point into risky assets. If the recession turns out to be much deeper, the defensive positioning will minimise losses.
Richard Maparura, Senior Portfolio Manager, Asset Management, Butterfield Bank (Cayman) Limited.
Sources: Charles Schwab Research & Bloomberg Economics
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.
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