In 2022 investors had to cope with a war in Europe, an energy crisis, a ‘cost-of-living’ squeeze, aggressive interest-rates increases – and falling equity markets almost everywhere. It was, arguably a terrible year. During 2023, the economic backdrop will deteriorate further – and it will be challenging for investors too.
There will be economic slowdowns, potential recessions, squeezed corporate margins and rising unemployment globally. However, as the year progresses, reasons for optimism are likely to emerge and 2023 should be much more positive for investors than 2022. Stock markets are forward-looking – investors look ahead. This means, as 2023 progresses, investors’ attention is likely to move on from the economic difficulties faced by many economies and eye a likely economic recovery in 2024 and beyond.
However, all of this will depend on data – investors need evidence that central banks have decisively got inflation back under control – without causing deep recessions. This is particularly true of the US Federal Reserve, which has been the most aggressive central bank in the world so far. So, what will change in 2023? Senior Editor Garry White discussed the shifting investment outlook with Chris Ainscough, Director of Asset Management and Oliver Faizallah, Director of Fixed Income Research.
Five market predictions for the year ahead
Prediction one: The Federal Reserve will not cut interest rates in 2023
Federal Reserve officials have now enacted the sharpest series of interest-rate rises since the 1980s when inflation touched 14% and rates rose to almost 20%. Thankfully, there are now signs that the tough medicine is working, and US inflation appears to have peaked. Clearly, this is good news – but the battle to defeat inflation will continue throughout 2023.
Central banks continue to talk tough, but the market does not believe that the Federal Reserve – the most important central bank in the world – will be as tough as its chair Jerome Powell says it will. Investors have priced in a ‘Fed pivot’ much sooner than the central bank has indicated.
A central bank ‘pivot’ describes the point where it reverses the course of monetary policy, moving from a tightening bias to an easing stance. It indicates the interest-rate cycle has passed its peak and policy is moving from ‘hawkish’ to ‘dovish’.
This expectation was driven by concerns that the continuing aggressive action by central banks could cause a deep recession, as the ‘cost-of-living’ crisis was already forcing households to financially retrench. The doves appeared to calculate that fears of a harsh economic slump would dilute the desire for tough action and the Fed would put ease off to save the economy. In the summer of 2022, the idea of a Fed pivot in early 2023 grew.
Central bankers – particularly those at the Fed – stand accused of bearing some responsibility for runaway price rises. Their critics argue that QE and other support policies should have been withdrawn much sooner. This job will not be left half done – and getting inflation down to a 2% target is likely to result in economic pain. Investors that think there will be any significant reversal of interest rate policy in 2023 are likely to be disappointed. This is now a credibility issue for central bankers themselves. A ‘Fed pivot’ is unlikely before 2024.
Prediction Two: Central banks will win the battle with inflation
There are now compelling reasons to expect headline inflation to drift lower through the year, ending up closer to central banks’ 2% target by early 2024. Higher prices will mean a continuation of demand destruction – a sustained decline in the demand for a certain good in response to persistent high prices. Economies are expected to slow – or even be recession – which will also have an impact on demand.
Inflation in the price of goods is likely to continue to fall rapidly due to lower shipping prices and falling consumer demand as the ‘cost-of-living’ crisis will see households continuing to rein in spending. Rising inventory levels in some areas may even result in price falls in certain goods, as retailers become more aggressive with discounting to reduce stock levels. As the broad-based economic slowdown continues, hiring demand is also likely to fall, keeping a lid on wage growth.
Central bankers will also want to ensure that they finish the job to restore their credibility. Ultra-loose policies by central banks were implemented for far too long – and let inflation out of the box when economies started to reopen following the pandemic. The battle with inflation is the number one priority of central bankers and governments, so rates will remain high throughout the year and inflation will be tamed. Despite inflation remaining elevated in early 2023, by the end of the year, we should see more normal rates of inflation, with the 2% target brought into view in late 2023/early 2024 for some regions.
Prediction Three: The erosion of ‘worker power’ means no damaging US wage-price spiral
The biggest fear this year for central banks, particularly the US Federal Reserve, has been a wage-price spiral, as was seen during the 1970s.
A wage-price spiral is a prolonged loop in which inflation leads to higher wage growth, which itself fuels ever-higher inflation. It does this by rapidly increasing the cost of labour for businesses and the increased spending power these wage rise confer on workers. This is one of the reasons why the monthly employment report from the US Bureau of Labor Statistics has been essential reading for anyone assessing the prospect of future interest-rate rise by the US central bank.
Recently, workers have had a degree of leverage in their wage negotiation because companies have had difficulty hiring employees. Almost three years after Covid-19 hit, companies around the world still complain that they can’t get the talent they need. But with an economic slowdown certain and recession a possibility this balance of worker power is starting to shift – and is likely to shift significantly in 2023. With labour conditions clearly tightening, employees will become less inclined to request excessive settlements, particularly as inflation is likely to be falling.
This means that the Fed’s biggest fear – a wage-price spiral – is highly unlikely. The slowdown will loosen labour market conditions, keeping a lid on high or excessive wage settlements. This is good news for central bankers as they try to engineer a soft landing for the economy.
Prediction Four: Progress on relaxing China’s ‘zero-Covid’ policy will be patchy and slow
China’s tough ‘zero-Covid’ policy is being withdrawn and markets have been, quite rightly, optimistic about the move. Its reopening comes with hopes of a return to sustained growth and supply-chain issues faced by Western companies will be solved. However, there are several issues likely to derail this positive narrative during 2023.
Covid-19 was spreading rapidly before protests forced Beijing to relax strict social-distancing rules – and new case numbers are likely to accelerate. Relaxing pandemic restrictions risk a significant rise in deaths in a country where a low proportion of the elderly is vaccinated. Any winter wave of infections will be exacerbated by the lunar new year holiday at the end of January – with the world’s largest annual human migration potentially becoming a super-spreader event.
The country has a serious vaccine problem. The inoculation of the elderly has not been professionally managed and the Chinese-developed vaccine that has been deployed is not particularly effective. Chinese leader Xi Jinping is steadfastly unwilling to accept Western-developed mRNA inoculations and vaccine hesitancy amongst the elderly is pervasive.
A rapid reopening risks sparking a major winter wave of the virus that could rapidly overwhelm China’s healthcare system, as the initial outbreak did in Wuhan three years ago. This means that a return to normality will take some time and progress will be patchy and slow. There is even the possibility that President Xi will reverse his volte-face on his ‘zero-Covid’ policy and reintroduce harsh restrictions once more. Until the vaccination rate amongst the country’s elderly rises significantly, this risk remains high. China’s reopening will be fraught with pitfalls.
Prediction Five: M&A activity will pick-up significantly
Markets and company directors look ahead and make decisions on what the future holds. This means 2023 should be the year when investors and businesses move on from managing downturns and recessions to planning for the likely recovery in 2024 and beyond. Britain’s depressed share prices and the stubbornly weak pound means quality British companies are trading at bargain prices on a global basis. With a recovery eye, they will become more attractive.
In 2022, overseas buyers have sat on the sidelines. The value of inbound mergers and acquisitions (M&A) for British companies declined to its lowest in four years. This trend looks set to significantly reverse in 2023. Potential buyers have been put off by gloomy predictions, such as that from the Organisation for Economic Co-operation and Development (OECD) that UK economic growth will grind to a halt in 2023 and be the lowest in the G20 of leading economies apart from sanctions-hobbled Russia. However, the combination of low equity valuations and subdued sterling should start to offset international-buyer concerns as recovery comes closer into view.
Mid-cap companies in the FTSE 250 with international operations – and businesses that could act as bolt-on acquisitions for a larger predator – look like the ideal prey for international buyers. US equities are also trading at higher earnings multiples than those in the UK, so all-share deals will appear attractive.
The very significant currency advantage, low valuations and the prospect of green economic shoots emerging sets the stage nicely for a significant pick-up in M&A. British companies offer ‘bargain basement’ opportunities for the right buyer.
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