The end of an unprecedented easing cycle
The largest combined easing of monetary1 and fiscal2 policy is ending. Central banks from around the world have tightened3 over the past year to fight inflation that has proven to be stickier than anticipated. As central banks continue to hike4 official cash rates, a slowdown in economic growth is expected in 2023. In this outlook piece, we will explore the path of inflation and how global markets will respond to a slowing economy.
Unprecedented easing5 of monetary and fiscal policy saw one of the strongest aggregate demand recoveries from the COVID-19 recession. But supply couldn’t keep up with demand due to supply chain disruptions and workers not returning to work following the pandemic. This resulted in inflation, which was exacerbated by the energy crisis stemming from the invasion of Ukraine.
The good news is that ‘goods’ inflation has eased and could even turn negative in 2023 as supply chain disruptions continue to ease and energy prices have fallen sharply. But ‘services’ inflation is likely to remain high as labour shortage is expected to be more structural, which leads to higher domestic wage growth. Other tailwinds for more sticky6 inflation are consumer inflation expectations, and more structural forces from the significant capital investments required for energy transition and reshoring from deglobalisation.
Markets are expecting inflation pressures to subside in 2023. Longer-term inflation expectations from 10-year TIPS7 are now at 2.25% from their 3% peak. This perhaps suggest the markets are also expecting that central banks are winning the fight against inflation by forcing a growth slowdown which drives demand destruction. Where inflation will land in the medium or long-term is anyone’s guess, but one thing for sure, is that the level and volatility of inflation will be higher than recent history.
Recession is coming
Central banks are hiking rates but also reversing a decade of quantitative easing8. Such combined tightening in financial conditions9 is likely to result in a recession in the US in 2023 and with the UK and Europe probably already in recession driven by their energy crisis. While most market participants view recessions as mostly likely, they also expect the downturn to be relatively mild and short-lived, as there are no obvious private sector imbalances10 and businesses are not overextended.
Can markets see through the recession?
It’s important to understand what the markets are currently pricing in11 or discounting. Because market returns are driven by how events transpire compared to what is currently priced in, a recession in itself won’t drive the markets lower if it is already priced in. A year ago, markets were expecting that inflation would fall quickly and central banks would tighten on the margin. This was later proven too optimistic as central banks were on a path to one of the largest tightening cycles in history and markets reacted with significant selloffs across both equity and bond markets.
Today, the markets appear to be pricing in a mild recession, inflation fading and remaining low longer-term, and central banks kicking off an easing cycle in late 2023 resulting in economic recovery. China’s economy remains a wildcard that is expected to provide its own policy support following their reopening. Whether inflation will fade quickly enough and the speed to the Fed’s pivot12 (or pause) is probably the greatest debate among investors.
As for equities, corporate earnings tend to fall around 10% for a mild recession. Bottom-up analyst forecasts are still seeing positive earnings growth in 2023. This could see adjustments early in the year to reflect actual underlying conditions. There is scope for further declines in equity markets, even if multiples13 remain unchanged.
1Monetary policy: Tools such as setting the official interest rate on short-term borrowing, which are used by a nation’s central bank to control inflation and price stability (ensure prices for goods and services are increasing at a modest and stable pace).
2Fiscal policy: The amount of net government spending (taxation minus spending) to manage economic cycles and reduce the impact of recessions (a contraction in a nation’s economic activity).
3Tightening of policies (or tightening cycle): Cool down a nation’s economy by raising interest rates (monetary policy tool) and/or decrease government spending (fiscal policy tool). This is done in order to stifle consumer and corporate spending, encourage saving and therefore slow down the flow of money (i.e. inflation).
4Hike: an increase in an economy’s interest rates by the central bank of that country.
5Easing of policies: Stimulate a nation’s economy using monetary and/or fiscal policies, including the lowering of official interest rates or increasing of government spending. This is done to encourage consumer and corporate spending.
6Sticky: sticky inflation references the components of overall headline inflation numbers that are slower moving or more resistant to change.
7TIPS: Treasury Inflation-Protected Securities which are bonds issued by the US government that is linked to inflation.
8Quantitative easing: Additional monetary policy tools, such as increasing money supply (printing money), used by central banks when lowering of official interest rates is not enough to stimulate the economy.
9Financial conditions: The availability of credit. Tighter financial conditions mean higher interest rates, and more difficult to obtain credit.
10Private sector imbalances: Private sector references the consumer and corporate sector of the economy (i.e. those parts that aren’t public/government). When this sector is in imbalance it means that there is larger liability or debt balance than the value of assets/savings and therefore the private sector is in deficit.
11Priced in: refers to information or expectations taking into consideration by the market and already reflected in current market levels
12Fed pivot: Shift in the stance of the Federal Reserve (Central Bank of the US), from easing to tightening.
13Multiples: ratios used to examine the company’s share price relative to some form of metric based on the company’s performance (such as earnings, book value, sales). For equity, most notably the P/E ratio which is share price divided by earnings per share.
By: Frank Li, CFA
Date: 24 January 2022
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Societies Australia or the author’s employer.
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