Cracks are starting to appear in developed-market economies because of the aggressive tightening of monetary policy last year.
Although policymakers have intervened to avoid market contagion, we think these fissures are symptomatic of broad-based pressures that will see economic activity decline later this year, as developed markets enter a recession.
We’re expecting the pattern of cross-asset market returns to be very different in 2023.
Cash (in US dollars) was king in 2022, as the aggressive interest-rate hikes led by the Federal Reserve resulted in declines for most financial assets. But a recession this year will see the direction of interest rates reverse and corporate earnings fall.
Fixed income assets – particularly US government bonds and the highest-quality credit securities – may represent good value, while riskier cyclical assets are vulnerable to further retreat, potentially offering better entry levels as the year progresses.
Divergence between the direction of economic growth in the West and in China will make this a developed-market centred recession.
However, given the importance of the US and Europe in sustaining global demand, and the pervasive impact that shocks to risk sentiment have on risk premia globally, the effects on risk assets – assets that aren’t risk free – is expected to be felt across all regions.
The challenge to monetary policy
Amid concerns around the banking sector in the US and Europe, the market is rapidly dismissing the prospect of significant interest-rate hikes in the US and expects a cutting cycle to begin during the northern hemisphere summer.
Developed market central banks are, however, far from meeting their inflation targets. They need to weigh up the immediate threats to the financial system against the risk of injecting stimulus prematurely, entrenching high inflation into the system, and setting the scene for a tougher fight down the road.
For now, measures to mitigate risks in the financial system are being deployed to avoid contagion, and it’s plausible that interest-rate policy will remain focused on inflation. But these things are not unrelated, as financial-system stress does tend to dampen growth (and therefore inflation) in the medium term.
We continue to think that a recession must occur to free up spare economic capacity and ease the price pressures that have been haunting western economies since 2021.
Whether enough has already been done to limit credit creation and constrain economic activity, or whether policy rates will need to head even higher, is unclear.
But we’ve moved beyond that fleeting moment when falling inflation seemed to allow central banks to suspend their war on higher prices while growth was still robust, and all assets were able to recover some of their losses from early 2022.
From here, financial conditions are likely to tighten further – whether this is caused by a deterioration in economic activity, or via yet tighter monetary policy.
Correlation changes and investment strategy
The demand destruction that accompanies recession will see the correlation between bonds and equities turn negative (these asset classes moving in opposite directions) once more, as we saw in March’s banking turmoil.
This means:
- Cash is no longer king because some assets will generate positive excess returns in the coming downturn.
- Defensive strategies that are correlated to government bonds may help investors dampen the blow if and when cyclical assets fall in anticipation of a recession.
- Alternative assets with a track record of diversification from equities in downturns may also help protect portfolios.
Elsewhere, in this edition of the Investment Outlook, my colleague Abigail Watt explains why we think US monetary policy will continue to target inflation in the coming months, leading to a US recession starting in the third quarter.
I delve further into the topic of cross-asset market returns to show that analysing financial markets’ pattern of returns is the best way to determine what sort of macroeconomic environment is exerting the greatest influence.
With the banking sector under the spotlight right now, Andrew Fraser takes a longer-term view and asks whether the climate crisis poses any risks to the global financial system.
Sticking with the topic of ‘sustainability’, David Smith answers the provocative question: ‘was 2022 the death of ESG?’
I hope you enjoy this year’s first edition of Investment Outlook.